Revenue Recognition – Proposed Agenda

Revenue Recognition – ProposedAgenda

• Effective date and transition• A single model for revenue• Scope• Core principle and five steps• Presentation and disclosure• Other issues• Differences from IAS 18 and U.S. GAAP• What companies should be doing now• Summary

Effective date and transition

January 1, January 1, January 1 January 1 January 1January 1

2010 2011 2012 2013 2014 2015

Exposure Draft

Issued

June 24, 2010

Exposure Draft

Issued

June 24, 2010

FULL RETROSPECTIVE APPLICATION

Comments Ending

October 22, 2010

Comments Ending

October 22, 2010

Standard Issued

Second half of 2011

Standard Issued

Second half of 2011

Effective Date

End of 2014

A single model for revenue

• Single model• Contract-based• Asset and liability approach• Transfer of control to customer

Scope

• Inclusive – all entities in all industries• Excludes:– Lease contracts– Insurance instruments– Financial instruments– Certain nonmonetary transactions

• Must be contract with customer• Could be part in, part out

Core principle and five steps

Core principle: An entity shall recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the entity receives, or expects to receive, in exchange for those goods or services.

(ED par. 2)

The five stepsThe five steps

Identify the contract with the customer

Identify the contract with the customer

Identify the separate

performance obligations

in the contract

Identify the separate

performance obligations

in the contract

Allocate the transaction price to the

separate performance obligations

Allocate the transaction price to the

separate performance obligations

Recognize revenue

when the entity

satisfies each performance

obligation

Recognize revenue

when the entity

satisfies each performance

obligation

Determine the

transaction price

Determine the

transaction price

Step 1: Identify the contract with the customer

Contract: An agreement between two or more parties that create enforceable rights and obligations. (ED Appendix A)

Contract elements:•Commercial substance•Approval and commitment•Identifiable and enforceable rights of parties•Identifiable terms and manner of payment

Wholly unperformed, no termination penalty = no contractCustomer: A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities.(ED Appendix A)

Step 1: Identify the contract with the customerCombination, segmentation, and modification of contracts

Price interdependence: The amount of consideration in one contract is dependent on the amount of consideration in another contract. (ED par. 13)

Indicators of interdependence:•The contracts are entered into at the same time•The contracts are negotiated as a package with a single commercial objective•The contracts are performed either concurrently or consecutively

Step 1: Identify the contract with the customerCombination, segmentation, and modification of contracts, continued

Contracts interdependent pricing – combine

Contract elements lack interdependent pricing – segment if meet two conditions:1.The entity, or another entity, regularly sells identical or similar goods or services separately, and2.The customer does not receive a significant discount for buying some goods and services together with another goods or services in the contract (ED par. 15)

Step 1: Identify the contract with the customerCombination, segmentation, and modification of contracts, continued

Example – segmenting contracts

Company A enters into agreement with customer•Equipment and maintenance together = $500•Equipment sold separately = $470•Maintenance sold = $40

Step 1: Identify the contract with the customerCombination, segmentation, and modification of contracts, continued

A contract modification is any change in the scope or price of a contract, such as changes in:•Nature or amount of goods or services to be transferred•Method or timing of performance•Previously agreed pricing

Contract modifications may be initiated by either the customer or the entity

The five steps continuedThe five steps continued

Identify the contract with the customer

Identify the contract with the customer

Identify the separate

performance obligations

in the contract

Identify the separate

performance obligations

in the contract

Allocate the transaction price to the

separate performance obligations

Allocate the transaction price to the

separate performance obligations

Recognize revenue

when the entity

satisfies each performance

obligation

Recognize revenue

when the entity

satisfies each performance

obligation

Determine the

transaction price

Determine the

transaction price

Step 2: Identify the separate performance obligations in the contract

Performance obligation: An enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. (ED App. A)Distinct: A good or service is distinct if either:a.The entity, or another entity, sells an identical or similar good or service separately, or b.The entity could sell the good or service separately, because the good or service meets both of the following conditions:

i. It has a distinct function – a good or service has a distinct function if it has utility either on its own or together with other goods or services that the customer has acquired from the entity or are sold separately by the entity or by another entity, and

ii. It has a distinct profit margin – a good or service has a distinct profit margin if it is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service (ED par. 23)

Step 2: Identify the separate performance obligations in the contract, continued

Example – sale of product with option for additional product The entity, or another entity, sells an identical or similar good or service separately, or •Entity A sells product to Customer B for $500•A also provides B with a voucher for a 30 percent discount on future purchases for 60 days (up to $500)•A regularly provides a voucher for a 10 percent discount on sales within 60 days

Is the voucher a separate performance obligation?

The five steps continuedThe five steps continued

Identify the contract with the customer

Identify the contract with the customer

Identify the separate

performance obligations

in the contract

Identify the separate

performance obligations

in the contract

Allocate the transaction price to the

separate performance obligations

Allocate the transaction price to the

separate performance obligations

Recognize revenue

when the entity

satisfies each performance

obligation

Recognize revenue

when the entity

satisfies each performance

obligation

Determine the

transaction price

Determine the

transaction price

Step 3: Determine the transaction price

Transaction price: The amount of consideration that an entity receives, or expects to receive, from a customer in exchange for transferring goods or services, excluding amounts collected on behalf of third parties (for example, taxes). (ED Appendix A)

Step 3: Determine the transaction priceExample – determining the transaction price

Entity A grants Company B exclusive access to licensefor $200,000 plus royalties of 5% of B’s sales

Possible product sales

Possible royalties at 5%

Probability Expected consideration

1,000,000 50,000 15% 7,500

2,000,000 100,000 25% 25,000

3,000,000 150,000 40% 60,000

4,000,000 200,000 15% 30,000

5,000,000 250,000 5% 12,500

100% 135,000

What is the transaction price in this arrangement?

Step 3: Determine the transaction priceAdditional considerations

• Collectability• Time value of money• Non cash consideration• Consideration payable to the customer

Step 3: Determine the transaction priceAdditional considerations -- collectability

Unconditional

Right to Receive Payment

Reasonably Assured

Reasonably Assured

Measurement (probability-weighted

amount)

Measurement (probability-weighted

amount)

Revenue Recognition

Guidance

Revenue Recognition

Guidance

Measurement (probability-weighted

amount)

Measurement (probability-weighted

amount)

Step 3: Determine the transaction priceAdditional considerations – time value of money

• Payment due significantly before or significantly after transfer of goods or services

• Material financing component is recognized separately• Discount rate as if separate financing transaction with that

customer– Time value of money– Credit risk

Step 3: Determine the transaction priceAdditional considerations – time value of money, continued

Example – time value of money –Prepayment for future goods delivery

• Entity A sells product to customer for $100,000• Delivery in one year• Payment today• Entity A recognizes $100,000 contract liability• Discount rate of 10% equals a material financing

component

Step 3: Determine the transaction priceAdditional considerations – time value of money, continued

Example – time value of money continued

Day one journal entry:Dr. Cash 100,000

Cr. Contract liability 100,000

Monthly journal entry before delivery:Dr. Interest expense 833

Cr. Contract liability 833

Journal entry on delivery – after one year:Dr. Contract liability 110,000

Cr. Revenue 110,000

Step 3: Determine the transaction priceAdditional considerations – time value of money, continuedStep 3: Determine the transaction priceAdditional considerations – time value of money, continued

Example – time value of money –payment in the future for goods delivered now

• Entity A sells product to customer • Immediate delivery of goods• $110,000 to be paid in one year• Entity A recognizes $100,000 of revenue• Discount rate of 10% equals a material financing

component

Step 3: Determine the transaction priceAdditional considerations – time value of money, continued

Example – time value of money continuedDay one journal entry:

Dr. Accounts receivable 100,000Cr. Revenue 100,000

Monthly journal entry before delivery:Dr. Interest receivable 833

Cr. Interest revenue 833Journal entry on delivery – after one year:

Dr. Cash 110,000Cr. Accounts receivable 100,000Cr. Interest receivable 10,000

Step 3: Determine the transaction priceAdditional considerations – noncash consideration

• Measure at Fair value• If Fair value not available– Indirect measurement– Reference stand-alone selling price of goods or services

transferred

If you pay consideration to the customer, it would be:1.A reduction of the transaction price2.A payment for distinct goods or services received from the customer3.Some combination of 1 and 2

If (3) reduce transaction price for amount that exceeds the fair value of goods or services received

If (3) but cannot reasonably estimate fair value, default to (1)

Step 3: Determine the transaction priceAdditional considerations – consideration payable to customer

Step 3: Determine the transaction priceAdditional considerations –consideration payable to customer, continued

Example – slotting fees

Entity A sells 1000 units of product to reseller for $10,000Entity A pays reseller $1,000 for product placement serviceFair value of product placement service if $600

Step 3: Determine the transaction priceAdditional considerations – right of return

Example – refund liabilityEntity A sells 500 products for $50 eachEach product costs $35Customer may return any unused product within 30 days for a full refund

Returns Probability Expected returns10 25% 2.5

25 50% 12.5

40 25% 10

100% 25

Step 3: Determine the transaction priceAdditional considerations – right of return, continued

For how many products does Entity A recognize revenue?

475 (25 estimated returns)

What is the refund liability? 1,250 (25 x 50 sales price)What is the return asset? 875 (25 x 35 cost)Journal entry on delivery:

Dr. Accounts receivable 25,000Cost of sales 16,625Return asset 875Cr. Revenue 23,750 Refund liability 1,250 Inventory 17,500

The five steps continuedThe five steps continued

Identify the contract with the customer

Identify the contract with the customer

Identify the separate

performance obligations

in the contract

Identify the separate

performance obligations

in the contract

Allocate the transaction price to the

separate performance obligations

Allocate the transaction price to the

separate performance obligations

Recognize revenue

when the entity

satisfies each performance

obligation

Recognize revenue

when the entity

satisfies each performance

obligation

Determine the

transaction price

Determine the

transaction price

Step 4: Allocate the transaction price to the separate performance obligations

• Relative stand-alone selling price• No default to list price or contract price• Observable price (sold separately)• Estimate stand-alone selling price

– Expected cost plus margin– Adjusted market assessment

Example – allocating transaction price to separate performance obligations

Relative stand-alone selling price ($)

Ratio Allocated amounts ($)

Medical devicecost plus margin)

225,000 75%(225/300)

187,500

Maintenance support (stand alone selling price)

50,000 17%(50/300)

42,500

Specified software upgrade (market assessment)

25,000 8%(25/300)

20,000

Total 300,000 100% 250,000

Step 4: Allocate the transaction price to the separate performance obligations, continued

Step 4: Allocate the transaction price to the separate performance obligations, continued

• Changes in transaction price– Variable consideration– Changes in estimates

• No redo of allocation percentages– Reallocate per original allocation– Adjust period revenue if performance obligation already

satisfied

The five steps continuedThe five steps continued

Identify the contract with the customer

Identify the contract with the customer

Identify the separate

performance obligations

in the contract

Identify the separate

performance obligations

in the contract

Allocate the transaction price to the

separate performance obligations

Allocate the transaction price to the

separate performance obligations

Recognize revenue

when the entity

satisfies each performance

obligation

Recognize revenue

when the entity

satisfies each performance

obligation

Determine the

transaction price

Determine the

transaction price

Step 5: Recognize revenue when the entity satisfies each performance obligation

Satisfy performance obligation = transfer control

Control: A customer obtains control of a good or service when the customer has the ability to direct the use of, and receive the benefit from, the good or service. Control includes the ability to prevent other entities from directing the use of, and receiving the benefit from, a good or service. (ED par. 26)

• Continuous transfer– Construction contracts– Services contracts

• Recognize revenue in manner that best depicts transfer– Output methods (preferred)– Input methods– Passage of time

Step 5: Recognize revenue when the entity satisfies each performance obligation, continued

Statement of Financial Position (SOFP)• Contract asset – entity performs but not the customer• Contract liability – customer performs and not the entity• Unconditional right to consideration– Only passage of time before receive payment– Receivables (ASC 310 or IAS 32/39)Disclosures• Qualitative and quantitative• Amount, timing, uncertainty• Significant judgments

Presentation and disclosure

• Explicit• Implicit – customary business practices• Not a separate performance obligation• Recognize refund liability• Recognize asset (separate from inventory)• Probability-weighted estimate of refund• If cannot estimate – all liability no revenue

Other issues

Rights of return

• Latent defects – not separate PO• Defects after customer controls –separate PO• Either way – revenue deferral

Other issues

Product warranties

• Nonexclusive = sale• Exclusive– Substantially all rights = sale– Not substantially all rights = revenue over license term

Other issues

Licenses and rights to use

• PV of probability-weighted costs > price allocated to that PO• Update liability each reporting period• At PO level, not contract level

Other issues

Onerous performance obligations

Capitalize Don’t CapitalizeOther standards Obtaining contract

Direct labor Satisfied POs

Direct materials Can’t distinguish past/future

Allocations relate directly to contract

Charged to customer

Other because of contract

Other issues

Onerous performance obligations

• Guidance on transaction price applies• Gain or loss is difference between transaction price and

carrying value

Other issuesSale of non-financial assets

• Variable or uncertain consideration• Collectability• Warranties• Financing• Refunds• Long term contracts• Onerous performance obligations• Capitalized costs• Disclosures

Differences from IAS 18 and U.S. GAAP

• Understanding effects of new model• Controls and processes• Information gathering systems• Budgeting• Metrics

– Debt covenants– Compensation arrangements

• Merger negotiations

What companies should be doing now

• Full retrospective application• Single model

– Goods– Services– All entities– All industries– Limited exceptions

• Leases• Insurance• Financial instruments• Nonmonetary transactions

Summary

Summary, continuedSummary, continued

Core principle: recognize revenue for transfer of goods or services to customer at amount of consideration received

Identify the contract with the customer

Identify the contract with the customer

Identify the separate

performance obligations

in the contract

Identify the separate

performance obligations

in the contract

Allocate the transaction price to the

separate performance obligations

Allocate the transaction price to the

separate performance obligations

Recognize revenue

when the entity

satisfies each performance

obligation

Recognize revenue

when the entity

satisfies each performance

obligation

Determine the

transaction price

Determine the

transaction price