The New Revenue Recognition Standard –

Implications for Internal Audit

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Agenda Introductions

Overview of New Revenue Recognition Standard

5 Step Standard Summary

Timing

Implications for Internal Audit

Next Steps

Q&A?

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Introduction

Nimi Yogaratnam – QLogic Corporation, Senior Director, Internal Audit CPA, CISA Experience: 20 years

Scott Jones, Managing Director Protiviti (Orange County) CPA, Attorney Experience: 32 Years

– Peat Marwick Mitchell (now KPMG) – InterFirst Bank – First Interstate Bank – Arthur Andersen – Protiviti (effective May 2002)

Overview - Protiviti

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6th Largest Business Consulting Firm

3,500+ professionals

1,000+ clients

60+ offices

24 countries in Americas, Europe and Asia-Pacific

Clients include more than: 35% of all

Fortune 100 Companies

25% of all Fortune 500 Companies

20% of all Fortune 1000 Companies

Protiviti is one of the fastest growing consulting firms worldwide. Our 2013 revenues $530 million.

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"The world is too big for us. Too much is going on. Too many crimes. Too

much excitement. Try as you will, you get behind in the race in spite of

yourself. It's a constant strain to keep pace --- and still, you lose ground.

Science empties its discoveries on you so fast that you stagger beneath

them in hopeless bewilderment. The political world now changes so rapidly

you’re out of breath trying to keep pace with who’s in and who’s out.

Everything is high pressure. Human nature can’t endure much more!”

Introduction – Quote: The World Is Evolving Too Fast – Part I

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"The world is too big for us. Too much is going on. Too many crimes. Too

much excitement. Try as you will, you get behind in the race in spite of

yourself. It's a constant strain to keep pace --- and still, you lose ground.

Science empties its discoveries on you so fast that you stagger beneath

them in hopeless bewilderment. The political world now changes so rapidly

you’re out of breath trying to keep pace with who’s in and who’s out.

Everything is high pressure. Human nature can’t endure much more!”

Atlantic Journal -- June 16, 1833

Introduction – Quote: The World Is Evolving Too Fast – Part II

Revenue Recognition Joint Project

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Objective of project: – Develop a standard based on a single model to deal

with all types of contracts and business sectors. – ASC Topic 606 was introduced via ASU 2014-09

Some interesting facts:

ASU 2014-09 is 700 pages long

At 522 paragraphs, the Basis for Conclusions alone is longer than any U.S. GAAP standard ever written, except FAS 133

Prior to its release, the FASB held more than 650 meetings with users, preparers, etc. across many jurisdictions

• Final Standard Released May 28, 2014. • Effective for annual reporting periods beginning after

December 15, 2016

Revenue Recognition Humor

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High Level Application of Revenue Model

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Identify the contract with a customer 1

Identify the separate performance obligations in the contract 2

Determine the transaction price 3

Allocate the transaction price to the separate performance obligations 4

Recognize revenue when (or as) the vendor satisfies a performance obligation 5

Recognize revenue when: Control over promised goods or services are transferred to customers In an amount that reflects the consideration a company expects to be entitled to in exchange for those goods and services

Step 1 – Identify the contract with a customer

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Contracts can be written, oral or implied.

A contract exists if: • The contract has commercial substance (that is, the risk, timing, or amount of the

entity’s future cash flows is expected to change as a result of the contract). • The parties to the contract have approved the contract. • The entity can identify each parties rights and payment terms. • It is probable that the entity will collect the consideration to which it will be entitled in

exchange for the goods or services. Permissible to apply guidance to a portfolio of contracts if no material differences would result vs. applying to individual contracts. Combine contracts if the contracts are entered into at or near the same time. Contract modifications accounted for separately if the modification results only in the addition of a distinct good/service at a price that is commensurate with that additional good/service.

Scenario 1 – Identify the contract with a customer

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• A Manufacturer enter into a contract on March 1, 2014 to supply 1,000 widgets a month for $50 a unit. The contract ends in December 31, 2014. There are no automatic renewal provisions in the contract.

• During January and February 2015 the customer continues to buy 1,000 widgets each month.

• On March 1, 2015 the Manufacturer enters into a new contract to supply 2,000 widgets a month for $45 a unit.

• How should the manufacturer account for the widgets supplied in January and February 2015?

Step 2 – Identify the separate performance obligations in the contract

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A performance obligation is a promise in a contract with a customer to transfer a good or service to that customer.

A good or service is distinct (Capable of being distinct and distinct within the context of the contract) if either of the following criteria is met: • The entity regularly sells the good or service separately. • The customer can benefit from the good or service either on its own or together with other

resources that are readily available to the customer.

Notwithstanding the above criteria, a good or service in a bundle of promised goods or services is not distinct and, therefore, the entity would account for the bundle as a single performance obligation, if both of the following criteria are met:

• The goods or services in the bundle are highly interrelated and transferring them to the customer requires that the entity also provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted.

• The bundle of goods or services is significantly modified or customized to fulfill the contract.

Scenario 2 – Identify the separate performance obligations in the contract

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• A software company enters into a contract to supply a perpetual license, installation service and two years of post contract support.

• Post contract support includes telephone support and unspecified upgrades.

• How many performance obligations are in the contract? • How will your answer change if the software requires significant

customization as part of installation?

Step 3 – Determine the transaction price

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The transaction price is the amount of consideration an entity expects to receive in exchange for transferring promised goods or services to a customer, excluding any amounts collected on behalf of third parties (for example, sales taxes). When determining the transaction price, an entity would consider the effects of all of the following:

• Variable consideration

• The time value of money • Noncash consideration • Consideration payable to the customer

• Discounts • Rebates • Refunds/Price Protection • Return rights • Concessions

• Penalties • Royalties • Performance bonuses • Milestones • Profit sharing

Scenario 3 – Determine the transaction price

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• A manufacturer sells toys through a retail network for $75. • Each unit sold contains a rebate coupon for $10. • The manufacturer estimates that 50% of eligible rebates

will be redeemed. • What is the manufacturer’s transaction price?

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

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Allocate to each separate performance obligation the amount of consideration the entity expects to receive in exchange for satisfying that performance obligation. Allocate transaction price based on relative stand alone selling prices. Best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.

If a standalone selling price is not directly observable, an entity shall estimate the standalone selling price. VSOE/TPE/BESP hierarchy no longer expressly required. However, entity is supposed to “maximize observable inputs.

Allocate a discount proportionately to all performance obligations in the contract, unless the entire discount relates to only one or more, but not all, performance obligations in a contract If highly variable, consider a residual technique by reference to the total transaction price less the standalone selling price of other goods or services in the contract.

Scenario 4 – Allocate the transaction price to the separate performance obligations

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• A manufacturer sells product A and B for $4,000. • The manufacturer regularly sells product A for $3,000 and

product B for 2,000. • How should the manufacturer allocate the transaction price to

the product?

Step 5 – Recognize revenue when (or as) the vendor satisfies a performance obligation

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Revenue is recognized when control over a good or service is transferred to the customer.

Need to determine whether the entity satisfies the performance obligation over time by transferring control of a good or service over time. If the entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.

To determine the point in time when a customer obtains control of a promised asset and an entity satisfies a performance obligation, the entity would consider indicators of the transfer of control such as……..

• The entity has a present right to payment for the asset. • The customer has legal title to the asset. • The entity has transferred physical possession of the asset. • The customer has the significant risks and rewards of ownership of the asset. • The customer has accepted the asset.

Scenario 5 – Recognize revenue when (or as) the vendor satisfies a performance obligation

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• A contractor enters into a contract with a customer to build an apartment building.

• The goods and services are not distinct in the contract, so the arrangement is accounted for as a single performance obligation.

• The customer makes monthly progress payments and can terminate the contract at any time.

• When should the contractor recognize revenue?

Transition & Effective Date

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Transition Method 2015/2016 2017 Date of Cumulative Effect Adjustment

Full Retrospective Restate for all contracts Apply new revenue standard to all contracts

January 1, 2015

Retrospective Using One or More Practical Expedients

Restate for all contracts under the new revenue standard except for contracts covered by the practical expedients elected by the preparer

Apply new revenue standard to all contracts

January 1, 2015

Cumulative Effect at the Date of Adoption

These periods not restated for any contracts

Apply new revenue standard to new and existing contracts; disclose effect of applying new standard

January 1, 2017

New Revenue Model – Implications for Internal Audit

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Contract Terms • Processes and controls surrounding review of contract terms. Legal enforceability depends on the interpretation of the law and could vary across legal jurisdictions..

Performance Obligations

• Identifying and documenting performance obligations. Remember inconsequential or perfunctory obligations are not excluded. The evaluation must include how or when the obligations are performed.

Key Metrics and Performance

Indicators

• Many key metrics and performance indicators are based on reported revenue. Organizations may want to consider changes to key metrics and performance indicators.

Variable Consideration

• Entities need to develop a process to estimate all forms of variable consideration in determining the initial transaction price.

Time Value of Money

• The transaction price should reflect the time value of money when the contract includes a significant financing component. A practical expedient allows entities to disregard the time value of money for short-term contracts. Assumptions involved in determining discount rates need to be documented.

Contract Cost • Certain contract acquisition costs would need to be capitalized. Processes and controls need to be established to identify and record such costs.

New Revenue Model – Implications for Internal Audit

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Systems • Various system implications through the order to cash process depending on adoption approach. .

Industry specific impact

• Software and construction type arrangements may see a greater impact upon adoption. VSOE of the FV of the undelivered items would no longer be required to separately account for elements in a software arrangement. This may warrant a re examination of certain business practices.

Income Tax • The acceleration of revenue for book purposes may accelerate revenue for tax purposes. Book/Tax basis differences, transfer pricing implications.

Disclosures • New rules will require substantial disclosures – both annually and quarterly. Disaggregation of

revenues, Contract balances, Performance obligations and Significant judgments employed in recognizing revenues.

Commissions • ASC 606 may pull forward revenue recognition in many cases. Companies may have to evaluate if they really want to pay sales commissions earlier?

High Level Implementation Timeline

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Analyze Implement Design Sustain “Steady State”

2014 2015 2016 1/1/17

Optional retrospective Reporting period

May 28th, 2014 - Issuance of revenue recognition standard

Key: Analyze Design Implement Sustain

Effective date of revenue recognition

standard

Potential Scenarios:

Low impact

Moderate impact

High impact

Retrospective adopter

Next Steps

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1. Education: Review final standard and implementation guidance Monitor Transition Resource Group deliberations.

2. Analyze current revenue policy vs. the proposed standard to identify expected changes: 3. Depending on significance of accounting policy gaps, consider extent of Legal (or Tax)

involvement that may be required. 4. Perform a high level analysis of data gaps:

– Will required information be available from your existing processes? – Will system changes be required?

5. Develop high level approach regarding transition method: – Retrospective versus cumulative effect. – Consider complexity of performing the transition and whether specific tools/systems may be

required. 6. Identify and assess additional resource needs; internal / external; temporary or permanent. 7. Educate senior management team, key stakeholders and Board of Directors.

Take time to Learn, Diagnose & Assess now…..

Q & A