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Financial reporting developments The road to convergence: the revenue recognition proposal August 2010

To our clients and other friends

Financial reporting developments The road to convergence: the revenue recognition proposal

The Financial Accounting Standard Board (the FASB) and the International Accounting

Standards Board (the IASB) (collectively, the Boards) have jointly issued a proposed standard

to supersede virtually all existing revenue guidance under US GAAP and IFRS. Generally, the

Boards believe the new revenue model will accomplish the following:

► Remove the inconsistencies and weaknesses that currently exist in US GAAP

► Provide a framework for addressing revenue recognition issues

► Improve comparability of revenue recognition practices among industries, entities within

those industries, jurisdictions and capital markets

► Reduce the complexity of applying revenue recognition guidance by reducing the volume

of the relevant guidance

Revenue is defined under current US GAAP as ―inflows or other enhancements of assets of an

entity or settlements of its liabilities (or a combination of both) from delivering or producing

goods, rendering services or other activities that constitute the entity‘s ongoing major or

central operations.‖1 While this single definition of revenue exists, the authoritative guidance

for revenue recognition in the Accounting Standards Codification (ASC) was codified from

more than 200 individual pieces of literature issued by multiple standard setters. Most of the

existing US GAAP guidance is specific to certain transactions or certain industries, which has

resulted in numerous individual standards focused on very detailed matters. However, many

other topics within revenue recognition lack guidance or the existing guidance is unclear.

The proposed guidance specifies the accounting for all revenue arising from contracts with

customers and affects all entities that enter into contracts to provide goods or services to

their customers (unless those contracts are in the scope of other US GAAP requirements). In

addition, the existing requirements for the recognition of gains and losses on the sale of

certain nonfinancial assets, such as property and equipment, would be amended by the

proposed standard in order to be consistent with the measurement and recognition principles

in the proposed revenue model.

The proposed guidance outlines the principles that an entity would apply in order to report

decision-useful information regarding the measurement and timing of revenue and the

related cash flows. The core principle in the proposed standard is that an entity will recognize

revenue to depict the transfer of goods or services to customers at an amount that reflects

the consideration the entity expects to receive in exchange for those goods or services. The

principles in the proposed standard are applied using the following five steps:

1. Identify the contract(s) with a customer

2. Identify the separate performance obligations in the contract

3. Determine the transaction price

1 FASB Concepts Statement No. 6, Elements of Financial Statements (CON 6)




4. Allocate the transaction price to the separate performance obligations

5. Recognize revenue when the entity satisfies each performance obligation

An entity will be required to exercise judgment when considering the terms of the contract(s)

and all surrounding facts and circumstances, including implied contract terms, when applying

the proposed model. Further, an entity must apply the requirements of the proposed model

consistently to contracts with similar characteristics and in similar circumstances.

The Boards are proposing that companies adopt the new guidance retrospectively for all

periods presented in the period of adoption. The proposal does not include a proposed

effective date. Instead, the effective date will be considered as part of another project on the

effective dates for all of the major joint projects currently under way and expected to be

completed in 2011.

We have issued this publication to highlight some of the more significant implications of the

proposed revenue recognition model. In the coming weeks, we also will provide certain

industry-specific publications that will address, in further detail, the complexities and subtleties

that may give rise to significant changes to practice in those industries. We encourage

preparers and users of financial statements to read this publication and the forthcoming

supplements carefully and consider the potential effects of the proposed model on existing

revenue recognition practices. The issues discussed in this publication are intended to assist

companies in formulating feedback to the Boards that can help in the development of a high-

quality final standard. The discussions within this publication represent preliminary thoughts

and additional issues may be identified through continued analysis of the exposure draft (ED)

and as the elements of the ED change on further deliberation by the Boards.

The comment letter period ends on 22 October 2010 and the Boards also plan to hold public

roundtable meetings following the comment period to gather information and obtain the

views of interested parties about the proposed guidance. Interested parties should refer to

the ED on either of the Boards‘ websites for instructions on submitting comment letters and

registering for the roundtable events.

August 2010

Contents

Financial reporting developments The road to convergence: the revenue recognition proposal i

Chapter 1: Scope, transition and internal control considerations .................................... 1

1.1 Scope .......................................................................................................... 1 1.2 Transition .................................................................................................... 4 1.3 Internal control considerations ..................................................................... 4

Chapter 2: Identify the contract with the customer ........................................................ 6

2.1 Combination and segmentation of contracts .................................................. 8 2.2 Contract modifications ............................................................................... 11

Chapter 3: Identify the separate performance obligations in the contract .................... 14

3.1 Distinct goods and services ........................................................................ 15 3.2 Product warranties .................................................................................... 20

3.2.1 Quality assurance warranties ........................................................ 20

3.2.2 Insurance warranties .................................................................... 21

3.2.3 Differentiating between quality assurance and insurance warranties .................................................................................... 23

3.2.4 Combination warranties ................................................................ 23

3.2.5 Warranty costs ............................................................................. 25

3.3 Principal versus agent considerations ......................................................... 26 3.4 Consignment arrangements ....................................................................... 28 3.5 Customer options for additional goods ........................................................ 28 3.6 Sale of products with a right of return ......................................................... 31

Chapter 4: Determine the transaction price .................................................................. 33

4.1 Variable consideration ............................................................................... 34 4.2 Collectibility ............................................................................................... 38 4.3 Time value of money .................................................................................. 40 4.4 Noncash consideration ............................................................................... 42 4.5 Consideration paid or payable to a customer ............................................... 43 4.6 Nonrefundable upfront fees ........................................................................ 45

Chapter 5: Allocate the transaction price to the separate performance obligations ...... 48

5.1 Estimating standalone selling prices ............................................................ 49 5.2 Changes in transaction price subsequent to contract inception ..................... 53

Chapter 6: Satisfaction of performance obligations ...................................................... 55

6.1 Continuous transfer of goods and services .................................................. 57 6.2 Recognizing revenue when a right of return exists ....................................... 60 6.3 Repurchase agreements ............................................................................. 62

6.3.1 Written put option held by the customer ........................................ 62

6.3.2 Forward or call option held by the entity ........................................ 62

6.4 Licensing and rights to use ......................................................................... 64 6.5 Bill-and-hold arrangements ......................................................................... 66 6.6 Customer acceptance ................................................................................. 67

Contents

Contents


Chapter 7: Other measurement and recognition topics .................................................. 69

7.1 Onerous performance obligations................................................................ 69 7.2 Contract costs ............................................................................................ 72 7.3 Sale of nonfinancial assets .......................................................................... 74

Chapter 8: Presentation and disclosure ......................................................................... 76

8.1 Presentation — Contract assets and contract liabilities .................................. 76 8.2 Disclosure .................................................................................................. 76

8.2.1 Disaggregation of revenue ............................................................ 76

8.2.2 Reconciliation of contract balances ............................................... 77

8.2.3 Performance obligations ............................................................... 79

8.2.4 Onerous performance obligations .................................................. 80

8.3 Significant judgments in the application of the new standard ........................ 81

Chapter 1: Scope, transition and internal control considerations

Financial reporting developments The road to convergence: the revenue recognition proposal 1

1.1 Scope

The scope of the Boards‘ proposed guidance on revenue recognition includes all contracts

with customers to provide goods or services in the ordinary course of business. However, the

following contracts have been excluded from the scope of the proposed guidance:

► Lease contracts within the scope of Accounting Standards Codification (ASC) 8402 on

leases

► Insurance contracts within the scope of ASC 9443 on insurance

► Contractual rights or obligations (i.e., financial instruments) such as receivables, debt and

equity securities and derivatives4

► Guarantees (other than product warranties) within the scope of ASC 460, Guarantees

► Nonmonetary exchanges between entities in the same line of business to facilitate sales

to customers other than the parties to the exchange5

Entities will likely enter into transactions that are partially within the scope of the proposed

revenue recognition guidance and partially within the scope of other guidance. In their basis

for conclusions, the Boards noted that it would not be appropriate to account for such

contracts in their entirety under one standard or another. The Boards explain that different

accounting outcomes could result depending on whether the goods or services were sold on a

standalone basis or together with other goods and services. Under the proposed guidance, if

a contract is partially within the scope of the proposed revenue guidance and partially within

the scope of other guidance, entities would apply the separation and measurement

requirements of the other guidance first. If the other guidance does not specify how to

separate and initially measure any parts of the contract, the entity would apply the proposed

revenue recognition guidance to separate and initially measure those parts of the contract.

2 ASC 840, Leases 3 ASC 944, Financial Instruments — Insurance 4 This exclusion includes contracts within the scope of the following ASC Topics: ASC 310,

Receivables; ASC 320, Investments — Debt and Equity Securities; ASC 405-20, Extinguishments of

Liabilities; ASC 470, Debt; ASC 815, Derivatives and Hedging; ASC 825, Financial Instruments; and

ASC 860, Transfers and Servicing. 5 Refer to ASC 845, Nonmonetary Transactions



2 Financial reporting developments The road to convergence: the revenue recognition proposal

How we see it

Entities entering into transactions that fall within the scope of multiple areas of accounting

guidance currently have to separate those transactions into the elements that are accounted

for under different pieces of literature. The ED does not propose to change this requirement,

nor does it change how the appropriate separation model is determined (e.g., which

accounting model is used to separate elements subject to different literature); therefore, we

do not expect a significant change in practice. However, under current US GAAP revenue

transactions are separated into elements that are accounted for under different pieces of

revenue guidance (e.g., a multiple-element transaction that falls within the scope of both the

multiple-element arrangements guidance in ASC 605-25 and the construction-type and

production-type arrangements guidance in ASC 605-35). Under the proposed guidance, this

separation would not be required as there would be a single revenue recognition model.

Interaction with the current joint project on leases

The Boards are currently working on a joint leasing project for which an ED was issued on

17 August 2010. In many respects, the proposed performance obligation and

derecognition models for lessor accounting within the expected leasing model are

consistent with the principles in the proposed revenue model. For example, the

requirement to continually assess the amounts of expected variable consideration is

consistent between the models. Another similarity includes the determination of whether

the risks or benefits have transferred to the lessee under the leasing model, which would

then require accounting under the derecognition model (i.e., similar to a sale). This

compares to the concept of transfer of control under the revenue model.

However, some aspects of the proposed leasing model are notably different from the

proposed revenue model. The most significant difference relates to the recognition of a

gross asset (for the right to receive future lease payments) and a gross liability (for the

obligation to permit the lessee to use the leased asset). Under the proposed revenue

model, contract assets and liabilities are not recorded at contract inception (i.e., they are

deemed to be equal and net to zero) and would only be recorded when one party to the

contract performs under the contract before the other party (see Section 8.1). Under

current US GAAP, revenue accounting and the accounting for leases by lessors is very

similar, particularly with respect to the recognition of assets and liabilities for leased assets

in operating leases. We believe that the proposed gross recognition of assets and liabilities

under the leasing model will require an increased emphasis on determining whether a

contract with a customer is a lease that is within the scope of the leasing guidance.



Interaction with the current joint project on insurance contracts

The Boards are also deliberating6 a joint project on accounting for insurance contracts.

Based on the Boards‘ current views, we believe the concepts of the expected insurance

model are similar to the proposed revenue model. However, there are a handful of

significant differences that will require entities to challenge whether certain contracts fall

within the scope of the insurance model or the revenue model.

One significant difference in the proposed models relates to the timing of the recognition of

a contract. In some cases, a contract may exist under the proposed insurance model that

would not exist under the proposed revenue model. Under the proposed insurance model,

a noncancelable offer by an insurer to its customer is a triggering event that creates a

contract that must be accounted for. Under this model, the offer itself exposes the insurer

to risk and the customer‘s acceptance of the offer is generally not required for the insurer

to be at risk. Under the revenue model, one of the four criteria for a contract is that all

parties have approved the contract and are committed to satisfying their respective

obligations (see Chapter 2).

Another potential difference between the two models is the contract boundaries for those

contracts within the scope of each respective model. In the proposed insurance model,

renewal periods in which the insurer does not have the right to re-underwrite and re-price

are included in initial determination of the estimated transaction price and contract period

for purposes of measuring the contract. Conversely, under the proposed revenue

guidance, while renewal options are considered deliverables to which transaction

consideration is allocated at the inception of the contract (when and if those renewal

options are deemed to provide a material right to the customer), consideration is allocated

only to the right to purchase, not that actual good or service obtainable upon the exercise

of the option (see Section 3.5).

The accounting for contract acquisition costs will also vary between the two proposed

models. Under the proposed insurance guidance, the incremental cash outflows associated

with the acquisition of a contract become a component of the measurement of the policy

liability (fulfillment cash flows) that are recognized in income over time as the obligations of

the insurer are satisfied. Conversely, under the proposed revenue model all costs incurred to

acquire a contract (e.g., commissions) are expensed as incurred (see Section 7.2).

Finally, the presentation of revenue and costs of revenue for insurance contracts will differ

significantly from the presentation of revenue under the proposed model. Rather than

presenting revenue and cost of revenue separately in the statement of comprehensive

income, the proposed insurance model will require the recognition of only the margin on

the contract.

6 The IASB issued its exposure draft on accounting for insurance contracts on 30 July 2010;

however, the FASB has not yet issued its exposure document.



1.2 Transition

The Boards concluded that the proposed guidance should be applied retrospectively in

accordance with ASC 2507, which they believe will provide the users of financial statements

with useful comparative information for each year presented. While the Boards noted that

retrospective application could be burdensome for some entities, particularly those with a

large number of long-term arrangements, they ultimately rejected a prospective or limited

retrospective basis of adoption. The Boards believed that a prospective method of adoption

would not provide decision-useful information because the recognition and measurement

principles being applied to new contracts would not be comparable to those applied to

existing contracts. While the Boards also considered the possibility of limited retrospective

adoption, they were unable to identify a specific date for limiting the retrospective

application of the proposed guidance that would, on a cost-beneficial basis, be preferable to

full retrospective application. The Boards ultimately concluded that the ability to apply the

exceptions to retrospective application under ASC 250 and the expected considerable time

between the issuance of a final standard and its effective date (which has not yet been

proposed) will provide users the time and flexibility necessary to apply the proposed

guidance retrospectively.

How we see it

We believe the effort required to adopt this standard will be significant for companies in

many industries, including media & entertainment and software (where long-term licenses

are common), long-term construction and for all other entities that have performance

obligations requiring an extended period to fulfill. The Boards acknowledge in the basis for

conclusions that retrospective application may be burdensome for some preparers,

particularly those with many long-term contracts.

Additionally, to adopt the proposed guidance retrospectively, an entity will prepare all

estimates based on information known at the inception of the contract or, as applicable,

during the course of the contract when estimates are revised based on new information.

We believe, and the Boards also acknowledge, that estimating the transaction price without

using hindsight (i.e., based on actual experience with collectibility and variable

consideration) and estimating standalone selling prices will be difficult for many entities.

1.3 Internal control considerations

When considering the potential effects of the proposed revenue recognition model, entities

should consider not only the potential changes in accounting policies and accounting systems

(which will be significant for many entities), but the related changes needed in internal control

processes and procedures as well. The increased use of principles and reduction of

prescriptive guidance within the proposed model will require entities to use estimation and

7 ASC 250, Accounting Changes and Error Corrections



judgment in more areas than under today's guidance. For example, significant new estimates

and judgments could include:

► Whether a good or service includes a distinct profit margin and otherwise meets the requirements to represent a performance obligation (see Section 3.1)

► Estimated standalone selling price of performance obligations that are not sold separately (see Section 5.1)

► Variable consideration (e.g., royalties, milestone payments, payments for optional services) included in the initial estimate of the transaction consideration (see Section 4.1)

► Onerous performance obligations (see Section 7.1)

Estimation processes typically have higher levels of inherent risk associated with them than

routine data processes and, therefore, require increased internal controls. While these

changes will affect all entities, public reporting entities subject to the internal control

evaluation and reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002

("Section 404") will have to be prepared to report on these changes in internal control as well

as continue assessing whether or not internal control over financial reporting remains

effective. Further, as many of the proposed disclosure requirements (discussed further in

Chapter 8) represent new disclosures compared to today's requirements, these increased

disclosures will likely also expand the Section 404 assessment.

Chapter 2: Identify the contract with the customer


In order to apply the proposed revenue recognition model, an entity must first identify the

contract, or contracts, to provide goods and services to its customer. Any contracts that

create enforceable obligations fall under the scope of the proposed guidance and they may be

written, oral or implied by the entity‘s customary business practice. The entity‘s past business

practices may influence its determination of whether a contract exists based on whether past

practice has created an enforceable obligation.

For purposes of applying the proposed guidance, a contract exists only if all of the following

criteria are met:

► The contract has commercial substance (demonstrated when the entity‘s future cash

flows are expected to change as a result of the contract)

► The parties to the contract have approved the contract and are committed to satisfying

their respective obligations

► The entity can identify each party‘s enforceable rights regarding the goods or services to

be transferred

► The entity can identify the terms and manner of payment for those goods or services

Termination clauses within contracts are an important consideration when determining

whether a contract exists. The proposed guidance states that a contract does not exist under

the proposed model if either party can terminate a ―wholly unperformed‖ contract without

penalty. Any arrangement in which the entity has not provided the contracted goods or

services and the customer has not paid the contracted consideration is considered to be a

―wholly unperformed‖ contract.

How we see it

Oral or implied agreements

Considering oral or implied agreements to be contracts applicable to the proposed model

may be a significant change in practice for some entities. Staff Accounting Bulletin (SAB)

Topic 13 provides four criteria that must be met for the recognition of revenue, including

that ―persuasive evidence of an arrangement exists.‖ Further, SAB Topic 13 refers to

SOP 97-2 (codified in ASC 985-6058), which provides guidance on determining whether

persuasive evidence of an arrangement exists. Generally, that guidance indicates that if an

entity operates in a manner that does not rely on contracts to document formal

agreement, some other evidence must exist to document the arrangement (e.g., purchase

orders, online authorizations). Additionally, that guidance states that if an entity has a

customary business practice of using written contracts to document formal arrangements,

evidence of any arrangement exists only by a fully executed contract.

8 ASC 985-605, Software–Revenue Recognition




Example 1 — oral contract

IT Support Co. provides online technology support for consumers remotely via the

internet. For a flat fee, IT Support Co. will scan a customer‘s personal computer (PC) for

viruses, optimize the PC‗s performance and solve any connectivity problems. In many

instances, the customers must call IT Support Co. in order to obtain the services when the

customer is experiencing connectivity problems. When the customer calls to initiate the

transaction, IT Support Co. describes the services it can provide and states the price for

those services. When the customer agrees to the terms stated by the representative,

payment is made over the telephone.

In this example, IT Support Co. and its customer are entering into an oral agreement for IT

Support Co. to repair the customer‘s PC and for the customer provide consideration by

transmitting a valid credit card number and authorization over the telephone. The four

criteria above are all met with the last three criterion all met via the telephone

conversation and the charge to the customer‘s credit card.

How we see it

Considerations for change orders in construction-type contracts

The proposed model may represent a significant change in practice for unapproved, or

partially unapproved (e.g., unpriced) change orders for those construction-type contracts

within the scope of ASC 605-35. Change orders are modifications to a contract that change

the provisions of a construction-type contract without adding new provisions. In some cases,

the pricing and scope of change orders will be approved by all parties in a timely manner, but

the scope of a change order may be agreed to long before the parties agree to certain other

details, such as pricing. In some situations, the parties to the contract do not finalize the

terms and conditions of the change order until after completion of the contract.

Current guidance on contract accounting within US GAAP provides for the consideration of

change orders prior to having complete approval (i.e., prior to having a revised contract). If

it is probable that the costs will be recovered through a change in the contract price for a

partially approved change order, both costs and revenues may be recorded as equal

amounts in the period of the change. The costs may also be deferred until all parties agree

to the changes. If it is not probable that costs will be recovered through a change in the

contract price, the costs are expensed as contract costs in the period incurred (assuming

the contract price covers the costs of the change order).



Under the proposed guidance, an entity only applies the proposed revenue requirements to a

contract modification if the four criteria for a contract to exist are met. In any scenario in

which terms or conditions are not agreed to by both parties, the change order generally

would not be considered a contract for application of the proposed guidance. In this case,

any costs that meet the criteria for capitalization will be capitalized; otherwise, the costs

would be expensed. However, no revenue is recognized for a change order until the contract

criteria are met. This is a change in practice that may result in later recognition of revenue.

2.1 Combination and segmentation of contracts

In most cases, entities would apply the five-step model described above to individual

contracts with a customer. However, there may be situations in which the entity should

combine multiple contracts for purposes of revenue recognition. There also may be situations

that require an entity to segment single contracts in applying the proposed model.

When two or more individual contracts are linked to one another through price

interdependency, the proposed guidance requires an entity to combine those contracts and

accounts for them as a single contract. Price interdependency is generally apparent when the

amount of consideration promised for goods or services under a contract is dependent on the

amount of consideration promised under another contract. Paragraph 13 of the ED provides

the following indicators that two or more contracts have interdependent prices:

► The contracts are entered into at or near the same time

► The contracts are negotiated as a package with a single commercial objective

► The contracts are performed either concurrently or consecutively

It is important to note that the price of a particular contract is not interdependent with

another contract solely because a discount provided within the new contract is based on the

existing customer relationship (i.e., because of previous contracts between the two parties).

Determining whether multiple contracts contain interdependent pricing requires professional

judgment and depends on the facts and circumstance of each arrangement.



How we see it

The current multiple-element arrangements guidance within US GAAP contains a

presumption that separate contracts entered into at or near the same time with the same

entity or related parties were negotiated as a package and should be evaluated as a single

agreement. Further, ASC 605-25 is clear that the evaluation of whether multiple contracts

are treated as a single arrangement considers both the form and substance of an

arrangement. Often, vendors have continuing relationships with their customers, and this

business relationship will lead to numerous signed or oral arrangements between the two

parties. The existence of concurrent agreements suggests that these multiple agreements

may represent a single arrangement, and, as such, the timing and measurement of

revenue recognition might be affected by the terms of the overall arrangement. Further,

ASC 605-35 (for construction-type and production-type contracts) and ASC 985-605 (for

software transactions) provide guidance on when to combine separate contracts and treat

them as a single arrangement. Regardless of the underlying current ASC guidance, the

determination of whether to combine contracts requires the use of professional judgment

and careful consideration of all facts and circumstances.

The three indicators provided in the ED are generally consistent with the underlying

principles in the current ASC guidance on combining contracts. As a result, we anticipate

the proposed guidance will result in entities reaching similar conclusions about when to

combine contracts as they do today.

Conversely, an entity may determine that it is necessary to segment a single contract and

account for it as two or more contracts if the prices of goods or services promised in the

contract are independent of the prices of other goods or services in the contract. Under the

proposed model, goods or services are priced independently of other goods or services in the

same contract only if both of the following conditions are met:

► The entity, or another entity, regularly sells identical or similar goods or services separately

► The customer does not receive a significant discount for buying some goods or services

together with other goods or services in the contract

Based on the above, one might conclude that if a customer receives a significant discount for

buying some goods or services with other goods or services in the contract, the contract

should not be segmented. However, in the basis for conclusions, the Boards state that if the

entity has evidence that a discount relates only to some goods or services within a contract,

then the contract may still meet the criteria for segmentation. This indicates that an entity

does not have to assume that a discount for a particular good or service is a result of buying

the bundle of goods and services.



Once an entity determines that segmenting a contract is appropriate, the entity allocates the

total expected consideration to each identified segment of the contract in proportion to the

standalone selling prices of the goods or services within each identified segment. The

transaction price allocated to each segment is then allocated to the individual performance

obligations within each segment, as applicable. Subsequent changes in the amount of

expected consideration are allocated only to the identified segment to which those changes

relate. For example, any changes in the expected consideration due to changes in expected

variable consideration are allocated to the segment giving rise to the variability.

How we see it

There is little current US GAAP on segmenting a contract. Criteria for segmenting certain

long-term production-type or construction-type contracts exist within the guidance on

construction-type and production-type contracts in ASC 605-35, but segmenting generally

is considered optional, not mandatory, under that guidance. As a result, the concept of

segmenting a contract will likely be new to most entities. However, it is unclear how

frequently entities would actually segment a contract under the proposed guidance, as it

seems unlikely that the criteria discussed above would be met frequently. Further, in those

scenarios where the criteria are met, it seems less likely that segmenting the contract will

provide a different accounting result than simply identifying separate performance

obligations. The following scenarios illustrate this point.

Example 2 — segmenting a contract

Assume Company Z enters into a single contract to sell a handheld electronic gaming

device and two games for $300. Company Z determines that the handheld device and both

games are each distinct based on the proposed guidance; therefore, each product

represents a separate performance obligation under the contract. The standalone selling

prices of the handheld device and each game are $250, $25 and $25, respectively.

Company Z sells the three products separately and the customer is not receiving a

significant discount by purchasing the goods together. In this scenario, the contract meets

the criteria to be segmented; however, the treatment of the handheld device and two

games as three individual contracts (segments) or as three separate performance

obligations under one contract has no effect on the amount of promised consideration

allocated to each performance obligation and, accordingly, no effect on the timing of the

revenue recognized. That is, regardless of whether consideration is allocated to three

contract segments or three performance obligations, the allocation is performed on a

relative selling price basis.



Assume the same fact pattern as above, except that the customer is eligible to receive a

$30 rebate on the handheld device if the customer submits the appropriate paperwork.

Company Z provides this same rebate offer to customers purchasing the handheld on a

standalone basis. In this fact pattern, because the $30 in variable consideration is

attributable only to the handheld device, segmenting the contract may affect the timing of

revenue recognition. If Company Z segments the contract, the adjustment to the

estimated transaction price resulting from the probability-weighted expected rebate

redemptions is allocated in its entirety to the handheld device. Conversely, if Company Z

concludes the contract should not be segmented, the adjustment to the estimated

transaction price resulting from the rebate is allocated to all three performance obligations

based on relative standalone selling price (discussed further below in Section 5.2).

2.2 Contract modifications

When the parties modify a contract subsequent to contract inception, the entity must

determine whether the modification creates a new contract or whether the contract

modification should be combined with the existing contract. A contract modification is

described in the proposed guidance as any change in the scope or price of a contract,

initiated by any party to the contract. Paragraph 17 of the ED provides that a contract

modification may include a change in the nature or amount of the goods or services promised

to the customer, a change in the method or timing of performance under the contract by any

party or a change in the previously agreed pricing in the contract.

In their basis for conclusions, the Boards explain that modifications to contracts should follow

the same principles as those applied to the segmentation or combination of contracts. Under

the proposed model, if the contract modification is tied to the original contract through price

interdependency, the modified terms are accounted for as part of the original contract.

Alternatively, if the modifications to the contract provides for the provision of goods or

services priced independently, the additional goods or services are viewed as performance

obligations in a new contract accounted for independently.

The effect on the amount and timing of revenue recognition at the date of the contract

modification differs based on whether or not the modification is accounted for together with

the existing contract. A modification accounted for together with the existing contract

requires a reallocation of the consideration to the identified performance obligations. To the

extent the reallocation of transaction consideration affects satisfied performance obligations,

the entity would recognize the cumulative effect of the contract modification (positive or

negative) in the period the modification occurs. In effect, the cumulative accounting for a

contract modification would result in revenue recognized as though the modified terms had

been included in the existing contract. Conversely, if the entity concludes that the contract

modification results in a new contract, the entity would apply the proposed model separately

to the new performance obligations included in the contract modification.



Example 3 — contract modification

The Boards provide the following example in Paragraph IG3 of the ED to demonstrate the

accounting for contract modifications:

Scenario 1—services that do not have interdependent prices

An entity enters into a three-year services contract. The payment terms are $100,000

payable annually in advance. The standalone selling price of the services at contract

inception is $100,000 per year. At the beginning of the third year (after the customer had

paid the $100,000 for that year), the entity agrees to reduce the price for the third year of

services to $80,000. In addition, the customer agrees to pay an additional $220,000 for

an extension of the contract for 3 years. The standalone selling price of the services at the

beginning of the third year is $80,000 per year.

To account for the contract modification, the entity must evaluate whether the price of the

services provided before the contract modification and the price of the services provided

after the contract modification are interdependent. The services provided during the first 2

years are priced at the standalone selling price of $100,000 per year. Moreover, the

services provided during the subsequent 4 years are priced at the standalone selling price of

$80,000 per year. Hence, the entity concludes that the price of the contract modification

and the price of the original contract are not interdependent. Although the services are

provided continuously, the price of the services in the first 2 years and the price of the

subsequent services are negotiated at different times and in different market conditions (as

evidenced by the significant change in the standalone selling price of the service).

Consequently, the entity accounts for the contract modification separately from the

original contract. $20,000 of the $100,000 payment received at the beginning of the

third year (before the modification) is a prepayment of services to be provided in the

future years. Therefore, the entity recognizes revenue of $100,000 per year for the 2

years of services provided under the original contract and $80,000 per year for services

provided during the subsequent 4 years of services under the new contract.



Scenario 2—services that have interdependent prices

The facts are the same as Scenario 1 except that at the beginning of the third year the

customer agrees to pay an additional $180,000 for an extension of the contract for 3 years.

The services provided during the first 2 years are priced at their standalone selling price of

$100,000 per year. However, the services provided during the subsequent 4 years are

priced at a $40,000 discount [($80,000 standalone selling price per year × 4 years) –

($100,000 prepayment + $180,000 remaining payment)] and, therefore, their price is

dependent on the price of the services in the original contract. Hence, the entity concludes

that the price of the contract modification and the price of the original contract are

interdependent.

Consequently, the entity accounts for the contract modification together with the original

contract. At the date of modification, the entity recognizes the cumulative effect of the

contract modification as a reduction to revenue in the amount of $40,000 [($480,000 total

consideration ’ 6 years of total services × 2 years‘ services provided) − $200,000 revenue

recognized to date]. The entity recognizes revenue of $100,000 per year for the first 2

years‘ $40,000 in the third year, and $80,000 per year in the fourth, fifth, and sixth years.

How we see it

In certain industries, parties frequently modify contractual arrangements before

completion. Entities will have to determine whether such change orders are separate

contracts or modifications of the original contract under the proposed model. This

assessment will require the use of judgment as it will frequently be difficult to determine

whether the pricing of the change order is interdependent upon the pricing in the original

contract. The requirement to determine whether to treat a change order as a separate

contract or a modification to an existing contract is relatively consistent with current US

GAAP. However, the application of the requirement may change as a result of the

proposed guidance, resulting in different conclusions in some cases.

Chapter 3: Identify the separate performance obligations in the contract


A performance obligation is defined in the ED as ―an enforceable promise (whether explicit or

implicit) in a contract with a customer to transfer a good or service to the customer.‖ The

proposed guidance requires an entity to identify all promised goods and services and

determine whether to account for each good or service as a separate performance obligation.

Paragraph 21 in the ED provides examples of goods or services that may give rise to a

performance obligation.

Excerpt from the ED

21. Contracts with customers oblige an entity to provide goods or services in exchange for

consideration. Goods or services include the following:

(a) goods produced by an entity for sale (for example, inventory of a manufacturer);

(b) goods purchased by an entity for resale (for example, merchandise of a retailer);

(c) arranging for another party to transfer goods or services (for example, acting as an

agent of another party);

(d) standing ready to provide goods or services (for example, when- and if-available

software products);

(e) constructing or developing an asset on behalf of a customer;

(f) granting licenses, rights to use and options; and

(g) performing a contractually agreed task (or tasks).

How we see it

Properly identifying the individual performance obligations within a contract is a critical

component of the proposed revenue model as revenue allocated to each performance

obligation is recognized as each performance obligation is satisfied. Additionally, as

discussed further in Section 7.1, whether or not an arrangement contains onerous

components is determined at the performance obligation level.

The concept of identifying separate performance obligations is similar to identifying a

deliverable or element under current US GAAP. As a result, we believe that in many cases

entities that transact in multiple-element arrangements will identify a similar number of

goods and services under the proposed model as they do under current US GAAP.




However, the new guidance likely will have a significant effect on entities that do not

currently account for revenue transactions under the guidance for multiple-element

arrangements. For example, the guidance in ASC 605-35 for certain production-type and

construction-type contracts does not require an entity to identify the individual goods and

services within an arrangement. Under the proposed model, in a contract to construct an

office building, the construction firm may consider the (a) customized design, (b) engineering

and (c) construction to each represent separate performance obligations. Alternatively, the

construction firm may determine that the activities included within those services, such as

the erection the physical building, the electrical wiring within the building, and the heating,

cooling and ventilation within the building, represent separate performance obligations.

Since the model requires the evaluation of identified goods and services to determine

whether they are separate performance obligations, and the satisfaction of performance

obligations drives revenue recognition, the identification of goods and services is an

important first step. While the ED provides illustrative guidance on this topic, it remains

unclear exactly how this guidance applies to transactions that contain numerous steps to

complete. We expect that the guidance in this area, and the interpretation of this guidance,

will continue to evolve as the Boards move toward a final standard.

3.1 Distinct goods and services

In order to identify the performance obligations within an arrangement, an entity determines

which promised goods and services are distinct from one another. That is, distinct goods and

services are considered individual performance obligations. Contracts to provide goods and

services to customers will often contain multiple performance obligations.

The ED provides criteria for determining whether a good or service is distinct in Paragraph 23.

Excerpt from the ED

23. A good or service, or a bundle of goods or services, 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

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



How we see it

The determination of whether a good or service is distinct may in many cases be subjective

and require the application of considerable professional judgment. The best evidence that a

good or service is distinct is when the good or service is sold separately by the entity or any

other market participant.

Multiple-element transactions

Consistent with the determination of standalone value under current US GAAP, the

determination of whether or not a good or service is a distinct performance obligation may

require the use of judgment. When the good or service is sold separately, the conclusion is

straightforward. However, in the absence of standalone sales, the entity may still

determine that the good or service is distinct by showing that the good or service, while not

currently sold separately, could be sold separately. The Boards provide two criteria that

must be met to support that assertion — 1) the good or service has a distinct function and

2) the good or service has a distinct profit margin. Requiring that a good or service has a

distinct function is consistent with the guidance in ASC 605-25, which requires that a

deliverable have ―value to the customer on a standalone basis.‖ That is, for a good or

service to have a distinct function (i.e., the good or service has utility on its own or when

combined with another asset), the good or service is essentially required to be an asset

that generates some economic benefit (i.e., value) to the customer.

The criterion in the proposed guidance that the good or service have a distinct profit

margin, however, is not one that exists currently in ASC 605-25. While not included in

ASC 605-25, this concept is similar to the guidance on construction-type contracts in

ASC 605-35 that requires an element to have a different rate of profitability to be

accounted for separate from other elements. When a standalone selling price is known, the

profit margin is readily determinable in most cases. However, demonstrating a distinct

profit margin when a selling price is not observable (because the good or service is not sold

separately) is difficult. The Boards concluded that in the absence of an observable selling

price, the entity would have sufficient basis for estimating the selling price only when the

good or service is subject to distinct risks and the entity can identify the distinguishable

resources needed to provide the good or service. This represents a significant change in

the accounting for multiple-element arrangements today.



In summary, when an entity is unable to identify the resources necessary to deliver a good

or service when the good or service is not sold separately, it may not be able to

demonstrate a distinct profit margin and would, therefore, not account for the identified

performance obligation separately. We anticipate that this requirement will most

frequently affect transactions that include certain intangibles not sold on a standalone

basis, such as software always bundled with postcontract customer support (PCS). This is

because it will likely be difficult for entities to determine the standalone selling price for the

software and, for many entities, the same resources are used to create software

intellectual property as are used to provide PCS (e.g., development of if-and-when

available upgrades). It appears that under the proposed model, in such situations, the

software license may have to be combined with the PCS into a single performance

obligation.

Other transactions

The identification of multiple performance obligations within a single contract may

represent a significant change to certain transactions. For example, for those transactions

that currently fall under the guidance in ASC 605-35 on accounting for production-type

and construction-type arrangements, the proposed guidance is a significant change. The

guidance in ASC 605-35 generally allows the accounting for contracts to be based on the

entire contract (although segmenting does occur in limited circumstances). However, we

do not believe the proposed guidance would provide for a similar outcome, and expect that

entities with these types of arrangements frequently will identify multiple performance

obligations in each contract, based on the proposed model.

During the deliberations and drafting of the proposed model, the Boards received feedback

that it was difficult to understand the extent to which an entity would have to identify

goods and services, and the resulting performance obligations, in contracts containing

many goods and services, such as the construction of a building. While the Boards have

made clear that they do not believe an entity would have to identify every nail and brick as

a good or service, we believe it is still unclear as to what level of granularity an entity is

required to use to identify goods and services in applying the proposed model.

If a good or service is not distinct from the other goods and services in the contract, the

entity is required to combine that good or service with other promised goods or services until

a bundle of goods or services is distinct for purposes of applying the proposed model. The

combination of multiple goods or services could result in the entity accounting for all the

goods or services promised in the contract as a single performance obligation.



The requirement to combine goods or services that are not distinct with other goods or

services is a critical component of the proposed model, and may have a significant effect on

the timing of revenue recognition. It is important to understand that this requirement may

result in combining a good or service with other goods or services that, on their own, meet the

definition of distinct. Example 11 in the ED (Paragraph IG43) illustrates the bundling of certain

goods or services with other goods and services that will be delivered under the contract. In

that example, the construction firm identifies the following individual goods or services:

► Design services (engineering)

► Construction activities, including:

► Site preparation

► Foundation development

► Structure erection

► Piping

► Wiring

► Site finishing

► Contract management services

In the illustration, the entity concludes the design services are distinct because similar

services are sold separately by the entity and by its competitors. Further, the entity

concludes that while many of the construction activities are distinct, the contract

management services are not. Based on that conclusion, the entity determines it must

combine the contract management services with other goods and services until the bundle of

goods and services is distinct. In this example, the entity combines the contract management

services with a number of the construction-related goods and services (foundation

development, structure erection, piping, and wiring) as the entity determines they are all

related tasks and have inseparable risks. However, the entity determines the site preparation

and site finishing, while construction-related activities, have distinct risks and are therefore

separable from the other construction activities. As a result, in this example, the entity

ultimately concludes it has four distinct performance obligations: design services, site

preparation, construction activities and site finishing.



How we see it

The determination of whether or not a good or service should be treated as a distinct

performance obligation, as discussed above, is one that will require significant judgment.

However, if there are goods and services that are not distinct, the determination of which

other goods and services to combine them with will also require significant judgment, and

likely may provide different results than under current US GAAP today.

Generally, under current US GAAP for multiple element arrangements, when an element

cannot be accounted for separately (e.g., because it lacks standalone value), that element

is combined with the last delivered element. This results in the deferral of revenue

associated with that element until the last element in the contract is delivered. However, all

other elements that were determined to have standalone value remain unaffected and

continue to be accounted for separately. Conversely, under the proposed guidance, if an

entity determines that a good or service is not distinct, that good or service must be

combined with other goods and services until a distinct bundle of goods is identified. As

illustrated in the example above, an entity may combine nondistinct goods or services with

other goods or services that are distinct on their own. In that example, the Boards

concluded that the construction management services would be combined with certain

highly interrelated goods or services that shared similar risks. However, it remains unclear

how an entity makes the determination of which activities have similar risks.

When an entity transfers multiple goods or services to a customer at the same time,

the proposed guidance does not require the application of the proposed model to each

performance obligation separately if applying the proposed model to them together

would result in the same amount and timing of revenue recognition as if they were

accounted for separately.

How we see it

Although the proposed guidance does not require application of the recognition and

measurement guidance to each performance obligation when the performance obligations

are delivered to the customer at the same time, the disclosure requirements in the proposed

guidance, described in further detail in Section 8.2, may require those same performance

obligations to be identified and presented separately in disaggregated disclosures. As a

result, while an entity may not be required to separately identify which goods and services

delivered at the same time are separate performance obligations for revenue recognition

purposes, the entity may have to make that distinction for disclosure purposes.



3.2 Product warranties

Product warranties are commonly included in the sale of goods, whether explicitly stated or

implied based on the entity‘s customary business practices. Further, the price of warranties

may be included in the overall purchase price or separately listed in the agreement as an

optional product. The proposed guidance identifies two specific classes of warranties those

that cover latent defects (i.e., defects that existed at the time the goods were transferred to

the customer) and those that cover defects arising subsequent to the transfer of the goods.

3.2.1 Quality assurance warranties

The Boards concluded that warranties covering latent defects do not provide an additional

good or service to the customer (i.e., are not separate performance obligations). Instead, in

that circumstance the entity has not fulfilled its original performance obligation as it has

failed to provide a product free of defects. By providing this type of warranty, the selling

entity has effectively provided a quality assurance guarantee. For arrangements that include

a quality assurance warranty, the entity would evaluate its product sales to determine the

likelihood and extent of any defects in the products sold to its customers, updating this

analysis at each financial reporting date.

The amount of revenue deferred for quality assurance warranties is dependent upon the

entity‘s obligation under the warranty. When the entity is required to fully replace a defective

product, the ED stipulates that the entity may not record any revenue associated with that

unsatisfied performance obligation. Conversely, if the entity is required to repair a defective

product, the entity defers only that the portion of the transaction price attributed to the

components expected to be repaired or replaced. As the proposed model does not require the

allocation of consideration down to components of a product, it does not address how an

entity would defer revenue associated with a component of a product. However, based on

discussions with the Boards‘ staffs, we understand that one acceptable method would be to

measure the estimated selling price of the component by identifying the costs associated with

repairing or replacing the component and adding an appropriate margin.

Frequently, after an entity provides a good or service, conditions arise that effect the original

estimate of expected experience associated with quality assurance warranties. For example,

an entity may discover two months after a product is shipped that a part acquired from a

third-party manufacturer is defective and that a large percentage of those parts are going to

fail. Under the proposed model, an entity would reflect any revisions to estimates associated

with quality assurance warranties as an adjustment to the amount of revenue recognized for

the related performance obligation (as a quality assurance warranty actually represents an

unsatisfied performance obligation).



Example 4 — quality assurance warranty to replace defective part

An entity manufactures and sells video game cartridges. The entity replaces any defective

game cartridges within the first 90 days of sale. Based on the entity‘s historical

experience, it determines (based on a probability-weighted average calculation) it has a 5%

defect rate on cartridges sold. Assuming the entity sells 100 game cartridges for $40

each, it would record the following entries:

Dr. Cash/Receivables 4,000

Cr. Contract liability 200

Cr. Revenue 3,800

The entity recognizes the contract liability as revenue during the 90 days of the quality

assurance warranty period as it repairs or replaces defective parts (i.e., as it satisfies the

original performance obligation).

Thirty days after the entity sells its game cartridges, it discovers that the coprocessor chip

included in some of the games is defective. The entity now believes it will have a 20%

defect rate. As a result, the entity estimates $800 of the transaction price should be

deferred (rather than the $200 originally deferred). The entity would record this change in

estimate on the remaining performance obligation by recording the following entry:

Dr. Revenue 600


Example 5 — quality assurance warranty to repair defective part

Conversely, if the entity repairs, rather than replaces the defective cartridges, it would

initially defer only the revenue associated with the component of the game cartridges that

it expects to repair. If the entity estimates that it costs $12 to replace the defective

component of the cartridge and that a 50% margin is appropriate, it will defer $18 for each

expected defective cartridge, or $90 total (5 cartridges X $18 of transaction price

allocated to the warranty component), and record the following entries:



Cr. Revenue 3,910

3.2.2 Insurance warranties

If an entity offers a warranty that provides coverage beyond defects that existed at the time

of the sale, in essence the entity has provided an insurance warranty to the customer. The

Boards determined that this type of warranty represents a separate warranty service (i.e., an

―insurance warranty‖) and, therefore, represents an additional performance obligation.

Unlike a quality assurance warranty in which the delivery of defect-free goods is presumed to



have not yet occurred (thus, the performance obligation for delivery of the good is not yet

satisfied), the entity accounts for an insurance warranty by allocating a portion of the

transaction price to a separate performance obligation (the insurance warranty). The revenue

related to that portion of the transaction price is then recognized over the period the

warranty services are provided. We believe that in many cases an entity may determine that

the warranty service is provided continuously over the warranty period (i.e., the performance

obligation is an obligation to ―stand-ready to perform‖ during the stated warranty period).

Frequently, after an entity provides a good or service, conditions arise that effect the

original estimate of expected experience associated with insurance warranties. For example,

an entity may discover two months after a product is shipped that the cost of a part acquired

from a third-party manufacturer has tripled and it will cost the entity significantly more to

replace that part if a warranty claim is made. However, unlike quality assurance warranties

(for which the entity reflects any revisions to estimates as an adjustment to the number of

performance obligations satisfied, with a corresponding effect on the amount of revenue

recognized), the revenue allocated to an insurance warranty is not modified. This is because

the allocation of transaction consideration is based on the standalone selling price at the

time of the transaction and, under the proposed model, subsequent changes to standalone

selling prices are not reflected in the relative selling price allocation. (See Section 3.2.5

below for a further discussion of how the expected costs would be accounted for under the

proposed model.)

Example 6 — insurance warranty

An entity manufactures and sells computers, which include a quality assurance warranty

for the first 90 days. Additionally, the entity offers its customers an optional ―extended

coverage‖ plan under which the entity will repair or replace any defective part for three

years from the expiration of the quality assurance warranty. The entity determines that

the three years of extended coverage represent a separate performance obligation, as

during that period the entity will repair or replace parts with defects that did not exist at

the time of the sale of the product. The total transaction price for the sale of a computer

and the extended warranty is $3,600 and the entity determines the standalone selling

price of each is $3,200 and $400, respectively. Further, the entity uses a probability-

weighted average calculation (based on historical experience) and estimates it will incur

$200 in costs to repair latent defects that arise within the 90-day coverage period for the

quality assurance warranty. Based on the margin associated with the computer, the entity

determines a 40% margin is appropriate for those costs. As a result, the entity will record

the following entries:


Cr. Contract liability (quality assurance warranty) 280

Cr. Contract liability (insurance warranty) 400

Cr. Revenue 2,920



The entity recognizes the contract liability associated with the quality assurance warranty

as revenue during the 90 days of the quality assurance warranty period as it repairs or

replaces defective parts (i.e., as the entity satisfies the original performance obligation).

The entity recognizes the contract liability associated with the insurance warranty as

revenue during the contract warranty period.

3.2.3 Differentiating between quality assurance and insurance

warranties

In certain circumstances, it may be difficult to determine whether a warranty is simply

providing coverage for latent defects or if it is providing additional warranty services. In

assessing the objective of the product warranty, Paragraph IG18 of the ED provides that the

entity should consider factors such as the following:

► Whether the warranty is required by law - if the entity generally is required by law to

protect the consumer from the risk of purchasing a defective product, this indicates a

warranty providing such coverage is a quality assurance warranty

► Whether the product could have been sold without the warranty — when the entity can sell

the product without the warranty, it indicates the entity may not have an obligation to

cover latent defects and that the inclusion of a warranty is an insurance warranty

► The length of the warranty coverage period — generally, the longer the warranty period, the

higher the likelihood that the warranty (or part of the warranty) is an insurance warranty

Despite the inclusion of these factors within the proposed guidance, we believe it will often be

difficult for the entity to determine which type of warranty is being provided. For example,

many manufacturers provide long-term warranties on their products (e.g., a four-year

warranty provided by an auto manufacturer). Based on conversations with the FASB staff, we

understand that the staff believes an entity may conclude that those long-term warranties

are quality assurance warranties despite the length of the warranty. As a result, it is possible

that diversity in practice will exist in determining the classification of the type of warranty

issued for warranties with similar coverage terms.

3.2.4 Combination warranties

If an entity‘s warranty coverage covers both latent defects and defects arising after the time

of sale, the entity will have to account for both types of warranties under the proposed

model. While the ED does not explicitly illustrate a scenario in which a single warranty

provision serves both purposes, paragraph IG18 in the ED includes a parenthetical reference

to the potential for part of a warranty to be considered a performance obligation. In applying

the proposed model, the entity would allocate a portion of the transaction price to the

insurance warranty based on its relative standalone selling price, and account for the quality

assurance warranty separately from the insurance warranty.



Example 7 — combination warranty

An entity manufactures and sells cars. For most car models sold, the entity provides a

four-year, 48,000-mile quality assurance warranty. However, as part of a sales promotion,

the entity decides to offer a particular model with a 10-year, 100,000 mile warranty. The

entity determines that the 10-year warranty represents both a quality assurance and

insurance warranty. As the entity believes its standard warranty (4-years, 48,000 miles) is

a quality assurance warranty (see Section S3.2.3), it determines the extended period (the

additional 6-years, 52,000 miles) of coverage represents the insurance warranty.

Under the proposed model, the entity determines the standalone selling price for the

insurance warranty and accounts for that performance obligation separately. The entity

reaches the conclusion that the sale of the car includes two performance obligations, the

car itself (which has a quality assurance warranty associated with it) and the insurance

warranty for the extended period of coverage. The total transaction price is $32,000.

Based on a relative standalone selling price allocation, the entity allocates $29,500 to the

car and $2,500 to the insurance warranty. Further, using a probability-weighted average

estimate based on historical experience, the entity expects to incur $1,500 in costs

associated with repairing or replacing defective components of each car during the earlier

of four years or 48,000 miles after the car is delivered to the customer. Based on the

margin associated with the car, the entity determines a 20% margin is appropriate and

therefore defers $1,800 of the transaction price allocated to each car to reflect its

remaining performance obligation for the car. The entity would record the following entries:


Cr. Contract liability (quality assurance warranty) 1,800

Cr. Contract liability (insurance warranty) 2,500

Cr. Revenue 27,700

The entity recognizes the contract liability associated with the quality assurance warranty

as revenue during the quality assurance warranty period (4 years or 48,000 miles) as it

repairs or replaces of defective parts, (i.e., as the entity satisfies the original performance

obligation). The entity recognizes the contract liability associated with the insurance

warranty as revenue during the contract warranty period (once the quality assurance

warranty period has ended through the earlier of 10 years or 100,000 miles).



3.2.5 Warranty costs

Costs associated with fulfilling a warranty obligation, whether the warranty is a quality

assurance warranty or an insurance warranty, are expensed when incurred under the

proposed model. However, as discussed above, the treatment of changes in expected costs to

fulfill warranty obligations may differ depending on the type of warranty. Changes in

expected costs for quality assurance warranties are immediately reflected in an adjustment

to revenue. Further, if those costs increase to a level at which the expected costs exceed the

entire amount of transaction price allocated to the performance obligation, the entity may

have to recognize a liability for an onerous performance obligation. For example, an auto

parts supplier provides seats to an auto manufacturer. As the supplier works extensively with

the auto manufacturer on the design and specifications before providing the seat, it rarely

has quality assurance issues. However, in the rare instances defects do arise, the auto

manufacturer is forced to recall the automobiles with defective seats. The costs of the recall,

removing the defective seat and replacing it with a new seat will frequently exceed the

original amount of revenue recognized for the seat when sold to the auto manufacturer. As a

result, under the proposed model, the supplier will be required to reverse all revenue

recognized related to the seat, and account for any expected excess costs (compared to the

revenue reversed) as an onerous performance obligation. See Section 7.1 for further

discussion on onerous performance obligations.

Entities are required to continually assess their warranty provisions based on current

information to ensure that changes in the entity‘s environment or obligations are reflected in

the liability. These adjustments likely reflect both changes in the expected quantity of product

requiring repair and changes in the expected cost of completing the repair. It is unclear how

changes in expected costs of fulfilling warranty obligations will be accounted for under the

proposed model. While it seems contrary to the model to adjust the amount of revenue

associated with a quality assurance warranty when only the estimated costs have changed,

most entities do not track changes in cost estimates separately from changes in the quantity

of product requiring repair. As a result, previously recognized revenue may have to be

adjusted for revisions to both costs and quantities.

Conversely, for insurance warranties, changes in expected costs are not reflected as an

adjustment to revenue recognized. Because insurance warranties are treated as a separate

performance obligation, when cost estimates change, the entity is required to assess whether

or not the increase in costs have created an onerous performance obligation. If the entity

expects the present value of the costs to fulfill that warranty performance obligation to

exceed the transaction consideration allocated to the warranty services, the entity would be

required to recognize a liability and corresponding expense for the excess costs. See the

discussion of onerous contracts in Section 7.1.



How we see it

Under the proposed model, any obligation related to either quality assurance warranties or

insurance warranties results in an initial deferral of revenue, which is then recognized as

the warranty services are provided. As a result, in comparison to current US GAAP, the

timing of revenue recognition will be affected for all transactions including a quality

assurance warranty because current practice generally provides for the recognition of

revenue in full and the accrual of a liability for the incremental cost of satisfying the

warranty obligation. We do not expect there to be a significant change in the accounting

for separately priced extended warranties (insurance warranties). While the amount of

revenue allocated to such warranties will change (current US GAAP requires the stated

contractual amount versus the relative selling price allocated under the proposed model),

revenue related to such warranties generally is recorded ratably over the warranty period

under both the proposed model and under current US GAAP.

We believe it frequently will be difficult to distinguish between the two types of warranties.

As highlighted above, an entity has to account for changes in estimated costs associated

with fulfilling warranty obligations in a very different manner depending on the type of

warranty involved. This difference in treatment makes the distinction of which type of

warranty the entity is providing a significant one.

Additionally, the proposed requirement for the recognition of warranty costs as incurred

also represents a change in practice from current US GAAP for other than separately

priced warranties, under which warranty costs are estimated and accrued upon the sale of

the good. Under the proposed model, warranty costs are recognized before they are

incurred only in situations in which the costs of satisfying the obligation are expected to

exceed the transaction price associated with the related performance obligation and,

therefore, an onerous performance obligation exists.

3.3 Principal versus agent considerations

Certain sales contracts often result in an entity‘s customer receiving goods or services from

another entity that is not a direct party to the contract. The ED states that when other parties

are involved in providing goods or services to an entity‘s customer, the entity must determine

whether its performance obligation is to provide the good or service itself (i.e., the entity is a

principal), or to arrange for another party to provide those goods or services (i.e., the entity

is an agent). The determination of whether the entity is acting as a principal or an agent

determines whether revenue is recognized at the gross amount when the entity is a principal

or, when the entity is an agent, at the net amount after the principal (i.e., the supplier of the

goods) is compensated.



A principal‘s performance obligations in a transaction differ from an agent‘s performance

obligations. Since the principal controls the goods or services before delivery to the

customer, its performance obligation is to transfer those goods or services to the customer in

accordance with the contract. The agent only facilitates the sale of goods or services to the

customer in exchange for a fee or commission and never controls the goods or services prior

to delivery. Therefore, the agent‘s performance obligation is to arrange for another party to

provide the goods or services to the customer.

Because the identification of the principal in a contract is not always clear, the Boards

provided implementation guidance in Paragraph IG22 with indicators that a performance

obligation involves an agency relationship.

Excerpt from the ED

IG22. Indicators that the entity‘s performance obligation is to arrange for the provision of

goods or services by another party (that is, that the entity is an agent and shall

recognize revenue net) include the following:

(a) the other party is primarily responsible for fulfillment of the contract;

(b) the entity does not have inventory risk before or after the customer order, during

shipping or on return;

(c) the entity does not have latitude in establishing prices for the other party‘s goods

or services and, hence, the benefit that the entity can receive from those goods or

services is constrained;

(d) the entity‘s consideration is in the form of a commission; and

(e) the entity does not have customer credit risk for the amount receivable in

exchange for the other party‘s goods or services.

Although a principal may be able to relieve itself from the obligation to provide goods or

services by transferring that obligation to another party, the Boards have indicated that such

transfer may not always satisfy the performance obligation. Instead, the entity evaluates

whether it has created a new performance obligation to obtain a customer for the entity that

assumed the obligation (i.e., whether the entity is now acting as an agent).

How we see it

Existing US GAAP requires an entity to assess whether it is acting as a principal or an agent

when goods or services are transferred to end customers and the principles provided in the

proposed model are similar to the principles in the current standards. Therefore, we do not

expect significant changes in practice with regard to principal/agency relationship

determinations.



3.4 Consignment arrangements

Entities frequently deliver inventory on a consignment basis to other parties (e.g., distributor

or dealer). By shipping on a consignment basis, consignors are able to better market products

by locating them closer in proximity to the end user; however, they do so without selling the

goods to the intermediary (consignee).

Entities entering into a consignment arrangement must determine, upon delivery of the

inventory to the consignee, whether control of the inventory has passed to the consignee.

Typically, a consignor will not relinquish control of consignment inventory until the inventory is

sold to the end consumer or, in some cases, when a specified period expires. Additionally,

consignees commonly do not have any obligation to pay for the inventory other than to pay the

consignor the agreed portion of the sale price once the consignee sells the product to a third

party. As a result, revenue generally should not be recognized for consignment arrangements

when the goods are delivered to the consignee as control has not been transferred (i.e., the

performance obligation to deliver goods to the customer has not been satisfied).

How we see it

We do not expect the accounting for consignment arrangements to change significantly

under the proposed model. Current US GAAP requires an entity to determine whether the

risks and rewards of ownership have passed to the consignor, which in most cases will

correspond to the time that control has passed to the consignor under the proposed

guidance. See the discussion on differences between control and risks and rewards of

ownership in Chapter 6.

3.5 Customer options for additional goods

Many sales contracts allow customers the option to purchase additional goods or services.

These additional goods and services may be at a discount or even free of charge. Options to

acquire additional goods or services at a discount can come in many forms, including sales

incentives (e.g., free telephones), customer award credits (e.g., frequent flier programs),

contract renewal options (e.g., waiver of certain fees, reduced future rates) or other

discounts on future goods or services.

The proposed guidance states that when an entity grants a customer the option to acquire

additional goods or services, that option is a separate performance obligation only if it

provides a material right to the customer. The right would be material only if it results in a

discount that the customer would not receive otherwise (e.g., a discount that is incremental

to the range of discounts typically given for those goods or services to that class of customer

in that geographical area or market). If the discounted price in the option is within the range

of prices typically offered to other similar customers (separate from any existing relationship

or contract), the entity is deemed to have made a marketing offer rather than having granted

a material right. The assessment as to whether the entity has granted its customer a material

right will likely require judgment.



Example 8 — option that is not a performance obligation

A telecom entity provides its customers the option to purchase additional minutes in

excess of the allotted amount in the customers‘ contracts, but the rate per minute is

consistent for all customers with that particular usage plan. In this circumstance, the

telecom entity would likely decide that the option for additional minutes is not providing its

customers with a material right.

Example 9 — option for additional goods that represents a separate performance obligation

A biotech entity may enter into a collaboration arrangement with a pharmaceutical

company whereby the biotech company provides research and development services and

agrees to manufacture a drug for the pharmaceutical company at cost if successful

development and FDA approval is achieved. In this fact pattern, the biotech entity likely

would determine that the option for the pharmaceutical company to receive the

manufactured drug at the biotech entity‘s cost represents a material right. As a result, the

biotech entity would treat that option as a separate performance obligation. Under the

proposed model, the biotech entity would estimate the standalone selling price of that

option, allocate transaction consideration to the option and recognize the revenue when

either the pharmaceutical company exercises the option for discounted manufacturing or

the option expires.

How we see it

Current US GAAP for software revenue recognition (ASC 985-605) addresses some of the

difficulties in distinguishing between (a) an option to acquire goods or services at a

significant discount and (b) a marketing offer. The guidance provides that an offer of a

discount on future purchases of goods or services is presumed to be a separate option in

the contract if that discount is significant and is incremental both to the range of discounts

reflected in the pricing of other elements in that contract and to the range of discounts

typically given in comparable transactions. The guidance in ASC 985-605 is often applied

by analogy to transactions other than software transactions.



Identification of options as separate performance obligations

The proposed guidance explained above is similar to the existing US GAAP guidance in

ASC 985-605. Accordingly, for most transactions, we do not expect significant changes in

practice regarding the identification of an option that represents a material right as a result

of the proposed guidance. However, we do expect a significant change for transactions

including goods or services considered to be contingent deliverables (such as the potential

manufacturing of a drug in Example 9 above). While there is diversity in practice, currently

many entities do not consider these contingent items to be deliverables under the

arrangement. As a result, such contingent items are excluded when the entity is identifying

the deliverables and determining which deliverables are separate units of accounting to

which the transaction consideration is allocated. Under the proposed model, an entity

would have to consider whether these contingent items provide a material right to the

customer (e.g., because of favorable pricing terms on the contingent items).

Measurement of options that are separate performance obligations

The measurement of an option providing a material right, once identified, will differ from

the model currently provided in ASC 985-605. The general principal in ASC 985-605

indicates that a proportionate amount of a significant future discount (i.e., the option)

should be applied to each element within the arrangement (including elements that are not

optional and must be delivered under the contract) based on their relative fair value.

However, if the future elements to which the discount applies are not specified or if vendor-

specific objective evidence (VSOE) of fair value of the future elements does not exist, the

maximum amount of the discount (if quantifiable) must be allocated to the elements in the

arrangement. If the maximum amount of the discount is not quantifiable, the discount rate

is applied to each element in the arrangement.

Example 10 — option for additional software at a discount

A vendor enters into an arrangement to license software products A and B to a customer

for a total of $200. Additionally, the vendor agrees to provide a discount of $30 if the

customer licenses either product C, D or E within a year of the inception of the

arrangement. The VSOE of fair value of both product A and B is $100. The VSOE of fair

value of products C, D and E range from $100 for product C to $400 for product E. The

future discount is more than insignificant.



Under ASC 985-605, the vendor should allocate the discount proportionately based on the

relative VSOE of fair value of products A, B and C (because product C is the lowest possible

fair value of the future purchase on which the discount may be used). The overall discount

rate is 10% ($30 discount divided by the total VSOE of fair value of products A, B and C of

$300). The amount of arrangement consideration allocable to the sale of products A and B

is $180 (the arrangement consideration of $200 reduced by the overall discount of 10%).

The remaining $20 (arrangement consideration of $200, minus the amount allocable to

products A and B of $180) should be recorded as deferred revenue and recognized on the

earlier of the customer‘s purchase of either product C, D or E or the expiration of the

discount period. However, if VSOE did not exist for products C, D or E, ASC 985-605

requires that the maximum amount of the discount, or $30, should be deferred

(i.e., discounting the delivered products by the entire discount amount).

How we see it

However, under the proposed model, the entity treats the option to future discounted

purchases as a separate performance obligation and must determine the estimated

standalone selling price of that option (even in situations in which the future goods and

services to which the discount applies are not specified). Allocation of transaction price to

the option is based on that estimated standalone selling price.

Example 11 — option for additional software at a discount (continued)

Continuing the example above, under the proposed guidance (and consistent with current

practice for multiple-element arrangements other than software), the vendor should

allocate the transaction price to the individual performance obligations within the contract

in proportion to the standalone selling prices of goods underlying each performance

obligation. The amount allocated to the significant and incremental discount would be

recognized in revenue when the performance obligation is satisfied (i.e., when the

customer purchases products C, D or E, or after the option period expires). For example,

the vendor may conclude that the best estimate of selling price for Product A, Product B

and the option to purchase future products at a discount is $100, $100 and $15,

respectively. As a result, the vendor will allocate the total arrangement consideration of

$200 to Product A, Product B and the option on a relative selling price basis, which is $93,

$93 and $14, respectively.

3.6 Sale of products with a right of return

An entity may provide its customers with a right to return a transferred product. Similar to

product warranties, a right of return may be contractual or may be an implicit right that exists

due to the entity‘s customary business practice. A customer exercising their right to return a

product may receive a full or partial refund, a credit applied to amounts owed or applicable to

other goods or services, another product in exchange or any combination thereof.



Offering a right of return in a sales agreement obliges the selling entity to stand ready to

accept a returned product. However, the Boards decided that such an obligation does not

represent a separate performance obligation under the proposed model. Instead, the Boards

concluded that an entity has made an uncertain number of sales when it provides goods with

a return right. That is, until the right of return expires unused, the entity is not certain how

many sales will fail. Therefore, the Boards concluded that an entity should not recognize

revenue for sales that are expected to fail as a result of the customer exercising their rights

to return the goods. This concept is discussed further in Section 6.2.

The Boards point out that exchanges by customers of one product for another of the same

type, quality, condition and price (e.g., one color or size for another) are not considered

returns for the purposes of applying the proposed requirements.

Chapter 4: Determine the transaction price


The proposed guidance defines the transaction price as ―the amount of consideration that an

entity receives, or expects to receive, from the customer in exchange for transferring goods

or services, excluding amounts collected on behalf of third parties (for example, taxes).‖ In

many cases, this is readily determinable as the entity receives payment at the same time it

transfers the promised goods or services and the price is fixed. However, determining the

transaction price may be more challenging when it is variable in amount, when collectibility is

uncertain, when payment is received at a time different from when the entity provides goods

or services or when payment is in a form other than cash. Additionally, consideration paid or

payable to the customer may also affect the determination of transaction price.

An entity recognizes revenue associated with completed performance obligations based on

the estimated transaction price, as long as the entity is able to reasonably estimate the

transaction price. The proposed model indicates that the following conditions must exist in

order for the entity to have the ability to estimate the transaction price:

► The entity has experience with similar types of contracts

► The entity‘s experience is relevant to the contract because the entity does not expect

significant changes in circumstances

An entity‘s experience with similar types of contracts does not have to be its own. For

example, an entity may not have experience with a certain type of contract but its competitor

does. If the entity has access to information about the competitor‘s experience, then the

entity can use the competitor‘s experience as a proxy for its own. However, experience alone

is not enough. That experience, whether an entity‘s own or that of others, must be relevant

to the contract. The circumstances surrounding the current contract should be similar to

those used as the basis of experience. Determining when experience is relevant will be

dependent on the applicable facts and circumstances and will require the use of professional

judgment.

To help with this assessment, Paragraph 39 of the ED specifies factors that, if present, may

suggest that an entity‘s experience is not a sufficient basis for a reasonable estimate.

Excerpt from the ED

39. Factors that reduce the relevance of an entity‘s experience include the following:

(a) the consideration amount is highly susceptible to external factors (for example,

volatility in the market, judgment of third parties and risk of obsolescence of the

promised good or service);

(b) the uncertainty about the amount of consideration is not expected to be resolved

for a long time;

(c) the entity‘ s experience with similar types of contracts is limited; and

(d) the contract has a large number of possible consideration amounts.




An entity‘s assessment of the relevance of its experience is not limited to these factors. Other

factors may exist that indicate an entity‘s experience is not a sufficient basis for a reasonable

estimate. Likewise, the existence of one or more of the above factors would not necessarily

prevent an entity from making a reasonable estimate of the transaction price.

Subsequent changes in the estimated transaction price should be updated at each reporting

period. Expectations about variable consideration should be revised for uncertainties that are

resolved and any new information about remaining uncertainties. Changes to the transaction

price should be allocated to all of the performance obligations in the contract (or contract

segment, see discussion in Section 2.1) so that the cumulative revenue recognized equals what

would have been recognized if the new information had been known at contract inception.

If the entity lacks the ability to make a reasonable estimate, the transaction price is limited to

the amount of consideration that is fixed or that can be reasonably estimated.

4.1 Variable consideration

The transaction price reflects an entity‘s expectations about the consideration it will receive

from the customer. A portion of the transaction price could vary in amount and timing for

such things as discounts, rebates, refunds, credits, incentives, bonuses/penalties,

contingencies or concessions. For example, a portion of the transaction price would be

variable at contract inception if it requires meeting specified performance conditions and

there is uncertainty regarding the outcome of such conditions. Alternatively, a portion of the

transaction price would not be considered variable at contract inception if it is contingent on

the entity‘s delivery of all of the goods and services identified in the contract. For example,

the transaction price would not be considered variable in an arrangement in which an entity is

obligated to provide three pieces of furniture, and the failure to deliver any of those goods

results in a partial refund to the customer for each undelivered piece.

Under the proposed guidance, variable consideration is measured based on a probability-

weighted estimate. Under this approach, the entity‘s estimate identifies the possible

outcomes of a contract and the probabilities of those outcomes. The ED indicates the Boards

believe this approach best reflects how contracts are negotiated and priced. Further, the

Boards believe the probability-weighted approach provides more consistent accounting for

similar contracts than alternative approaches, such as a predictive approach. A predictive

approach would predict the most likely or probable outcome and use that threshold as the

basis for revenue recognition. Under that approach, similar contracts could have different

accounting depending on how closely a contract passes or misses the threshold.



Example 12 — probability-weighted estimate of expected consideration

A long-term contractor enters into an arrangement that states the contractor will receive a

$100,000 performance bonus if the contractor meets specified performance targets. The

contractor has performed these types of contracts in the past, and has determined it has

the ability to make a reasonable estimate of whether it will earn the performance bonus.

The contractor has determined that it believes it is 80% likely it will receive the entire

performance bonus, and 20% likely it will receive none of the bonus. As a result, the

contractor would include $80,000 [($100,000 x 80%) + ($0 x 20%)], in the transaction

price associated with this potential performance bonus. Comparatively, under current US

GAAP, the contractor would include $100,000 in the transaction price as that reflects the

amount the entity believes it is likely to receive under a predictive approach.

How we see it

For a number of entities, the treatment of variable consideration under the proposed

model will represent a significant change from current practice. While there are certain

exceptions, most current US GAAP limits the amount of revenue recognizable to the

amount that is not contingent upon the satisfaction of performance obligations in the

future. As a result, entities likely will recognize revenue sooner for variable amounts under

the proposed model. However, for certain industries, the proposed model actually may

result in a delay in revenue recognition from current practice.

Example 13 — probability-weighted average estimate accelerates revenue recognition

compared to current practice

A biotech company enters into a collaboration arrangement with a pharmaceutical

company to provide a license of certain intellectual property rights and ongoing research

and development (R&D) activities to further develop those rights. Under the agreement,

the biotech is eligible for two potential milestone payments. The first milestone payment of

$5 million is received upon enrollment of the first clinical patient in phase II clinical trials

and the second milestone payment of $10 million is receive upon FDA approval of a drug

candidate based on the intellectual property.



Under current US GAAP, the biotech would not recognize any revenue associated with

those milestone payments until the milestone is achieved. (While there is diversity in

practice as to the amount of revenue recognized upon achievement of the milestone, no

contingent revenue is recognized prior to that point.) Conversely, under the proposed

model the biotech would determine the probability-weighted estimate of the consideration

expected to be received based on the likelihood of performance targets being met (if

reasonably estimable). The probability-weighted estimate of expected milestone payments

would be included in the total transaction price allocated to the performance obligations,

and recognized as those obligations are satisfied. In many cases, that will result in at least

some of the potential milestone payments being included in the estimated transaction

price and recognized in revenue prior to the actual receipt of the milestone payments.

That is, it would be rare that biotech would conclude that the probability of collecting the

associated milestone payment remains at zero or is not reasonably estimable until

immediately prior to collection.

In this example, the biotech may determine at contract inception that the likelihood of

obtaining the first milestone payment is 15%, and that the likelihood of achieving the

second milestone payment is not reasonably estimable. As a result, biotech includes

$750,000 [($5 million x 15%) + ($10 million x 0%)] associated with the milestones in the

total estimated transaction price at the onset of the contract. The total estimated

transaction price is then allocated to the identified performance obligations.

At the end of year one, the entity determines the likelihood of obtaining the first milestone

payment has increased to 60%. The entity will have to adjust the estimated transaction

price by $2,250,000 (or the difference between the current probability-weighted average

estimate of $3 million [($5 million x 60%) + ($10 million x 0%)] compared to the original

estimate of $750,000.

However, during year two, as a result of negative developments in the R&D activities,

biotech determines the likelihood of obtaining the first milestone payment is now zero.

Biotech would have to reduce the estimated transaction price to exclude all amounts

associated with the milestone payments ($3 million) and, to the extent such amounts were

allocated to completed performance obligations, reverse revenue previously recognized.

Example 14 — probability-weighted average estimate delays revenue recognition

compared to current practice

An asset management company (e.g., a hedge fund) has an arrangement with a customer

whereby, under the terms of the arrangement, the asset manager receives a fee of 2% of

the total annual return on the assets in the portfolio. The annual performance is measured

based on the 12-months ended 31 May each year.



Current US GAAP provides the asset management company an accounting policy election

for the recognition of those performance based fees — one choice allows revenue

recognition prior to the end of the performance period and the finalization of the

performance fee. Therefore, if the funds had earned $20 million as of 31 December, the

asset manager could have recognized $400,000 in revenue if that were the accounting

policy selected.

Conversely, under the proposed model, as the amount of performance fees are not

estimable (i.e., the fees are based in large part on external factors and an entity cannot

estimate how the market will perform over a specific period of time), the asset

management company would not be able to recognize any revenue as of 31 December and

would have to wait until the end of the performance period to recognize those

performance-based fees.

How we see it

Further, the use of a probability-weighted average estimate to determine the amount of

expected contingent consideration is likely a new requirement for many entities currently

applying US GAAP. While certain areas of current guidance require a similar approach to

making an estimate (e.g., fair value determinations for financial instruments, measurement

of an asset retirement obligation), probability-weighted average calculations currently do

not have wide-spread application under US GAAP. Further, these estimates will have to be

updated at each reporting date.

In performing a probability-weighted average estimate, it is unclear how many possible

outcomes an entity is required to consider. While the range of potential outcomes likely

affects this conclusion, an entity will have to use judgment to determine what reasonable

number of possible outcomes (and their likelihood of being achieved) is appropriate.

Finally, under current US GAAP, in situations in which variable payments may be included

in the transaction price, the approach is generally a predictive approach. That is,

management includes what it determines to be its best estimate of the amount to be

received. Comparatively, the use of a probability-weighted average approach will likely

provide different results (which may not be a possible outcome under the contract as

illustrated in the example below).



Example 15 — variable consideration

An entity enters into a long-term contract within the scope of ASC 605-35 that includes a

$2 million performance bonus. Under current US GAAP that entity would include in the

total transaction price 100% of the amount that it believes is probable of receipt. Assume

that the entity believes there is 70% likelihood that it will not earn the performance bonus

and a 30% likelihood that it will earn it. Under current practice, the entity would include

zero in its determined transaction price because the receipt of the bonus is not probable.

However, under the proposed model, the entity would include $600,000 [(70% x $0) +

(30% x $2 million)], which is not a possible outcome under the contract. This estimate

would continue to be updated each reporting period. If the entity determines in six months

that it is now 90% likely it will not receive the performance bonus and only 10% likely that it

will, it will reduce the amount of transaction consideration by $400,000. To the extent the

transaction price has been allocated to completed performance obligations, the entity will

recognize a reduction in revenue in that period.

4.2 Collectibility

In determining the transaction price, the entity must also consider the effects of collectibility.

Collectibility refers to a customer‘s credit risk — that is, the customer‘s ability to pay the

amount of promised consideration. In many contracts, the effect of the customer‘s credit risk

is immaterial. For example, in a retail transaction an entity collects the promised

consideration from the customer at the point of sale. The entity would recognize as revenue

the entire amount of promised consideration. However, in some cases, the consideration is

not received at the point of the transfer of the good or service and an entity expects a portion

of their customers to default. In such contracts, the transaction price should reflect the

possibility that the entity will not receive all of the promised consideration, based on a

probability-weighted approach of the potential outcomes. Similar to the requirements for

measuring variable consideration, the proposed model requires that an entity must be able to

make reasonable estimates of collectibility. If it cannot, revenue should be recognized on a

cash basis or once an amount can be reasonably estimated.

Some entities enter into groups of similar contracts. The proposed model permits entities to

aggregate these contracts for purposes of recognizing the effects of collectibility on the

transaction price. An entity could recognize revenue for an individual contract based on its

invoiced amount and reduce the receivable and revenue for the effects of collectibility for the

group of contracts based on the probability-weighted amount of consideration the entity

expects to receive from the pool of contracts.

Any changes in the amounts expected to be collected or actually collected subsequent to the

satisfaction of the related performance obligation are recognized in other income or expense

(i.e., separate from revenue). The Boards decided that this approach was more consistent

with the proposed guidance based on the notion that once the performance obligation is



satisfied, there should be no changes in the revenue recognized. A reassessment of a

customer‘s credit risk is reflective of an impairment, or reversal of impairment, of the

receivable, resulting in a charge to other income or expense, not revenue. This is similar to

the accounting for noncash consideration received in exchange for a good or service for

which changes in value of the noncash consideration after performance is complete are

recognized outside of revenue.

How we see it

The proposed guidance on collectibility represents a significant change to how all entities

recognize revenue. The proposed model considers collectibility in the measurement of

revenue, while existing standards consider collectibility in the recognition of revenue. SEC

SAB Topic 13, Revenue Recognition, states that revenue can be recognized only if

―collectibility is reasonably assured.‖ As long as collectibility is reasonably assured, entities

recognize as revenue the full amount of promised consideration. Any doubts about a

customer‘s ability to pay are recognized as an allowance for doubtful accounts and bad debt

expense. If collectibility is not reasonably assured, an entity generally recognizes revenue on

a cash basis. As a result, in situations in which an entity determines that there is uncertainty

regarding an individual customer‘s ability to pay, considering collectibilty in the measurement

of revenue likely will result in earlier revenue recognition in those transactions. However, in

situations in which an entity is considering collectibility for a pool of customers the proposed

model is unlikely to have any effect on the timing of revenue recognition.

Additionally, requiring the uncertainty about an entity‘s ability to pay the promised

consideration to be reflected in the measurement of the transaction price, and therefore in

the amount of revenue recognized, will result in a permanent reduction in revenue, which

could be significant for entities that historically have had material bad debts, such as health

care entities. This will affect margins and other key revenue metrics for entities.

Example 16 — adjusting for risk related to collectibility

A vendor sells a piece of machinery for $2,000 and payment is due 45 days after the

machinery is transferred to the customer. The cost of the machinery is $1,500. Based on

its experience with similar contracts, the vendor estimates that there is a 15% probability

that it will not collect the promised consideration. Therefore, the transaction price is

$1,700 [(85% x $2,000) + (15% x $0)]. When the vendor transfers the machinery to the

customer, it recognizes a receivable and revenue of $1,700.

The vendor ultimately receives the full amount of promised consideration of $2,000.

Revenue is not grossed up for the $300 difference [$2,000 - $1,700] between the cash

received and the revenue originally recognized. Instead, the $300 is presented as other

income. Alternatively, if the vendor only receives $1,400, the $300 difference is

presented as other expense.



Under current US GAAP, the vendor would recognize a margin of $500 [$2,000 revenue -

$1,500 cost] and, because collection of the receivable is probable, no bad debt expense.

Under the proposed model, the vendor would recognize a margin of $200 [$1,700

revenue - $1,500 cost]. Collections above the amount of revenue recognized would not

improve margins.

How we see it

Measuring the effects of collectibility on the transaction price may be difficult to

implement. An entity may decide that grouping contracts is an easy way to estimate

collectibility for a large number of similar transactions, as illustrated in the following

example:

Example 17 — adjusting for risk related to collectibility (continued)

Continuing the example from above, assume the vendor sells the piece of machinery to

100 customers in April and decides to group these contracts since they have similar

characteristics (same machinery, pricing and terms and conditions of sale). Further,

assume that the vendor expects that, based on a probability-weighted average calculation,

15% of the receivables will prove uncollectible. The vendor records a receivable and

revenue for $200,000 ($2,000 invoiced amount x 100 customers) and a corresponding

reduction to the receivable and revenue of $30,000 to reflect the total consideration

expected to be received of $170,000 ($1,700 transaction price x 100 customers). During

the month of May, 60% of the customers pay in full and 10 customer pay only 70%, so the

vendor collects a total of $134,000 [(60 x $2,000) + (10 x 70% x $2,000)]. Additionally,

the vendor determines it will not collect any of $2,000 outstanding from five customers as

they each filed for bankruptcy during the month. As a result, by the end of May, the vendor

has collected $134,000, has written off $16,000 [(5 x $2,000) + (10 x 30% x $2,000)] as

uncollectible and has $50,000 remaining to be collected. The vendor estimates that of the

remaining $50,000 in uncollected receivables, $20,000 will prove uncollectible. Because

the sum of the $16,000 in receivables written off and the remaining $20,000 not

expected to be collected exceeds the original estimate of uncollectible receivables

($30,000), an allowance for doubtful accounts $6,000 must be recognized as an expense.

4.3 Time value of money

For certain transactions, the timing of the payment does not match the timing of the transfer

of goods or services to the customer (e.g., the consideration is prepaid or is paid well after

the services are provided). When the customer pays in arrears, the entity is effectively

providing a loan to the customer. Conversely, when the customer pays in advance, the entity

has effectively received a loan from the customer. In such situations, the entity would have to

consider the effects of the time value of money on the total transaction amount. If the effect

of the time value of money is material, the transaction price should be adjusted.



An entity should determine the transaction price by discounting the amount of promised

consideration. It should use the same discount rate that it would use if it were to enter into a

separate financing transaction with the customer, independent of providing other goods or

services. Using the risk-free rate or a rate explicitly stated in the contract that does not

correspond with separate financing rate would not be acceptable. Instead, the discount rate

should reflect the credit characteristics of the parties to the contract. Because this rate would

reflect the customer‘s credit worthiness (i.e., collection risk), an entity should not also adjust

the amount of promised consideration for collectibility.

How we see it

Many entities today do not consider the time value of money because it is not required for

short-term (i.e., one year or less) receivables that arise in the normal course of business.

Determining whether the effect is material will be dependent on the applicable facts and

circumstances and will require the use of professional judgment. The length of time

between payment and transfer of goods or services to the customer is not the only factor

that should be considered. There may be circumstances in which the effect of the time

value of money is material to a short-term contract because, for example, the customer‘s

credit worthiness is poor and a high rate would be used to discount that amounts to be

collected. Additionally, an arrangement may include a financing component even when the

timing of the payment matches the timing of the provision of services.

Example 18 — Arrangement includes financing component

An entity enters into a 3-year supply contract in which it agrees to provide the customer

with 15 pieces of major medical equipment at $1 million per unit. Based on its experience

with similar goods, the entity expects its production cost per unit to decrease over the 3-

year contract due to decreases in the cost of technology. On a standalone basis, the entity

estimates that it would price the product at $1.1 million, $1 million and $0.9 million in

each year, respectively, to reflect the expected cost trend. Effectively, the supplier is

financing any of the units purchased in the first year because the contract price is less than

the standalone selling price.

How we see it

The proposed treatment of the time value of money will likely have the most significant

effect for those transactions involving large pre-payments or payments in arrears. When

an entity receives a large pre-payment, the effect of accounting for the time value of

money in that transaction likely will result in the amount of revenue ultimately recognized

exceeding the consideration received. Conversely, transactions that provide for significant

payments in arrears likely will result in less revenue being recognized than the

consideration received.



Determining a customer-specific discount rate could be the most challenging aspect in

determining the effect of the time value of money on the transaction price. The proposed

guidance requires that the discount rate used be a rate similar to what the entity would

have used in a separate financing transaction with the customer. As most entities are likely

not in the business of entering into freestanding financing arrangements with their

customers, they may find it difficult to identify an appropriate rate to use. However, most

entities perform some level of credit analysis before financing purchases for a customer, so

the vendor will have some information about credit risk of the customer. For entities that

have differential pricing for products depending on the time of payment (e.g., cash

discounts), the proposed guidance indicates that the appropriate discount rate could be

determined by identifying the rate that discounts the nominal amount of the promised

consideration to the cash sales price of the good or service.

The financing component of a contract should be presented separately from the revenue

recognized. An entity would recognize the discounted promised consideration as revenue.

The financing component is recognized as interest expense (when the customer pays in

advance) or interest income (when the customer pays in arrears). The interest income or

expense is recognized over the financing period using the interest method described in

ASC 835, Interest.

4.4 Noncash consideration

Customer consideration might be in the form of goods, services or other noncash

consideration. When an entity receives, or expects to receive, noncash consideration, the

transaction price is equal to the fair value of the noncash consideration9. An entity would

apply the principles of ASC 820 in measuring the fair value of the noncash consideration. If

an entity cannot reasonably estimate the fair value of noncash consideration, it should

measure the noncash consideration indirectly by reference to the selling price of the

promised goods or services.

In some transactions, a customer contributes goods or services, such as equipment or labor,

to facilitate the fulfillment of the contract. If the entity obtains control of the contributed

goods or services, it should consider them noncash consideration and account for that

consideration as described above.

9 This statement applies only to transactions that are in the scope of the proposed guidance.

Nonmonetary exchanges between entities in the same line of business that are arranged to

facilitate sales to third parties (i.e., the entities involved in the exchange are not the end consumer)

are excluded from the scope of the proposed guidance.



How we see it

The concept of accounting for noncash consideration at fair value is consistent with

current US GAAP. However, under current US GAAP, an entity would first look to the fair

value of the goods or services surrendered and then to the fair value of the asset acquired

if it were more clearly evident. Under the proposed model, the order is reversed. An entity

first measures noncash consideration at the fair value of the goods or services received

and only looks to the fair value (i.e., selling price) of the goods or services surrendered if

the fair value of the goods or services received is not reasonably estimable. We would not

expect this nuance to have a significant effect on the measurement of noncash

consideration for most entities.

4.5 Consideration paid or payable to a customer

Many entities make payments to their customers from time to time. In some cases, the

consideration paid or payable represents purchases by the entity of goods or services offered

by the customer that satisfy a business need of the entity. In other cases, the consideration

paid or payable represents incentives given by the entity to entice the customer to purchase,

or continue purchasing, its goods or services.

Consideration paid or payable to customers commonly takes the form of discounts, coupons,

free products or services and equity instruments, among others. In addition, some entities

will make payments to the customers of resellers or distributors that purchase directly from

the entity (e.g., manufacturers of breakfast cereals commonly offer coupons to the

consumers of their products, although the manufacturer‘s direct customers are the grocery

stores that sell to the consumers). Other common forms of consideration paid or payable to

customers include the following:

► Slotting fees, in which a vendor provides consideration to a reseller to ―obtain space‖ for

the vendor‘s products on the reseller‘s store shelves, whether those shelves are physical

(i.e., in an actual building in which the store is located) or virtual (i.e., they represent

space in an internet reseller‘s online catalog)

► Cooperative advertising arrangements, in which a vendor agrees to reimburse a reseller

for a portion of costs incurred by the reseller to advertise the vendor‘s products

► Buydowns or price protection, in which a vendor agrees to reimburse a retailer up to a

specified amount for shortfalls in the sales price received by the retailer for the vendor's

products over a specified period of time

► Coupons and rebates, in which an indirect customer of a vendor may receive a return of a

portion of the purchase price of the product or service acquired by returning a form to

the retailer or the vendor



In order to determine the appropriate accounting, an entity must first determine whether the

consideration paid or payable to a customer is:

► A reduction of the transaction price

► A payment for a distinct good or service

► A combination of both

If the consideration paid or payable to a customer is a discount or refund for goods or

services provided to a customer, an entity should reduce the transaction price, and thus

revenue, by the amount paid or payable to the customer. This reduction should be recognized

at the later of when the entity transfers the promised goods or services to the customer or

the entity promises to pay the consideration, even if the payment is conditional on a future

event. If the consideration paid or payable to a customer includes variable consideration, an

entity would measure the reduction of the transaction price using the probability-weighted

approach (see Section 4.1 for further discussion). Further, the promise to pay the

consideration might be implied by the entity‘s customary business practice. For example, if

goods subject to a discount through a coupon are already on the shelves of retailers, the

discount would be recognized when the coupons are issued. However, if a coupon is issued

that can be used on future purchases of products that have not yet been sold to retailers, the

discount would be recognized upon sale to a retailer.

If the consideration paid or payable to a customer includes variable consideration such as

volume discounts, an entity would measure the reduction of the transaction price using the

probability-weighted approach (see Section 4.1 for further discussion). Further, the promise

to provide the discounts might be implied by the entity‘s customary business practice.

If the consideration paid or payable to a customer is in exchange for distinct goods or

services received from the customer, than an entity should account for the goods or services

received in the same way as any other purchases in the normal course of business. In other

words, the goods or services would be capitalized or expensed in accordance with other

US GAAP, rather than a reduction in revenue. An entity should use the same criteria to

determine whether a good or service is distinct as described earlier with respect to

identifying performance obligations.

In some cases, the amount of consideration received from the customer and any payment of

consideration to that customer could be linked, yet the vendor could also receive distinct

goods or services. For instance, a customer may pay more for goods or services than it would

otherwise have done if it was not receiving a payment from the entity for other goods or

services provided by the customer. This situation is treated as both a reduction in the

transaction price and payment for a distinct good or service. Under the proposed model, the

entity determines the fair value of the good or service it received from the customer and

compares it to the consideration payable to the customer. Any excess of the consideration



payable over the fair value of the distinct goods or services received would reduce the

transaction price. If the entity cannot reasonably estimate the fair value of the good or

service received from the customer, the entity should account for the entire consideration

payable to the customer as a reduction of the transaction price.

How we see it

Generally, the accounting for consideration payable to a customer under the proposed

model is consistent with current US GAAP. However, the determination of whether a good

or service is ―distinct‖ under the proposed model may differ from the current

determination under US GAAP of whether the vendor has received an ―identifiable

benefit.‖ For example, under current US GAAP, slotting fees are generally treated as a

reduction of revenue for the reasons described in the following paragraph. However, under

the proposed model as illustrated in Example 23 of the ED, slotting fees could be treated as

a payment for a distinct good or service, and therefore recognized as expense, or a

combination of a reduction in revenue and a payment for a distinct good or service.

Slotting fees generally are characterized as a reduction of revenue under current US GAAP

because they do not meet the identifiable benefit criteria. In order to meet this condition,

the identified benefit must be sufficiently separable from the recipient's purchase of the

vendor's goods such that the vendor could have entered into an exchange transaction with

a party other than a purchaser of its goods or services in order to receive that benefit.

Although a slotting fee may provide the vendor with an identifiable benefit in the form of

an exclusive right to provide a particular good to a retailer or reseller, the vendor could not

obtain such a benefit separately from the sale of its goods to the customer.

Conversely, as described earlier, the proposed guidance states that a good or service is

distinct if it is sold separately or could be sold separately because it has a distinct function

and profit margin. While a slotting fee is not sold separately, the illustrative guidance in the

ED indicates that the fee is for a distinct service (stocking, displaying and supporting the

products). As a result, the entity may determine the services has a distinct function (it has

utility together with the related goods or services) and a distinct profit margin (it is subject

to distinct risks and the entity can separately identify the resources needed to provide the

slotting fees). If an entity reached that conclusion, it would be a change from the current

accounting for those fees.

4.6 Nonrefundable upfront fees

In certain circumstances, entities may receive payments from customers in advance of

rendering a contracted service or delivering a good. Upfront fees generally relate to the

initiation, activation or set up of a good to be used or a service to be rendered in the future.

Upfront fees also may be paid to grant access to or a right to use a facility, product or

service. In many cases, the upfront amounts paid by the customer are nonrefundable.

Common examples of upfront fees are fees paid for membership to a health or buying club

and activation fees for phone, cable or internet usage.



Entities must evaluate whether nonrefundable upfront fees relate to the transfer of a good or

service. In most situations, the upfront fee would not have been paid without continuing use

of the good or service. Therefore, the fee does not relate to the actual transfer of a good or

service. Instead, the upfront fee is an advance payment for future goods or services.

Consequently, the upfront fee should be recognized as revenue when the future goods or

services are transferred to the customer. The period of recognition of the upfront fee should

include optional renewal periods to the extent that the renewal option is a material right (see

discussion in Section 3.5 for further discussion on renewal options).

There may be some situations in which an entity determines that a nonrefundable upfront fee

does relate to the transfer of a good or service. In this case, the entity will need to determine

if the good or service associated with the nonrefundable upfront fee is a separate

performance obligation.

How we see it

It is unclear whether the proposed guidance will result in a significant change in practice.

Under current practice, an upfront fee generally is recognized over the longer of the

contractual period or the expected customer relationship period.

Under the proposed guidance, when a transaction includes a non-refundable up-front fee,

entities will need to carefully analyze not only whether there is a distinct up-front

performance obligation associated with that fee, but also whether it indicates there are

other performance obligations in the contract that should be identified. For example, the

proposed model indicates that the existence of such a fee may provide the customer with

the ability to get future services at a discounted rate. In many transactions a customer

pays an up-front fee as part of entering into a contract. However, the customer can renew

the contract each year without paying the up-front fee again, which may indicate that the

entity has provided the customer with an option to purchase discounted services in the

future. Even in situations in which the entity determines that an option has been provided,

the period to which the option relates (and therefore the period over which the allocated

revenue would be recognized) is not necessarily the same as the contractual period or

expected customer relationship period.



Example 19 — non-refundable up-front fees

A customer signs a one-year contract with a health club and is required to pay both a

nonrefundable upfront membership fee of $150 and monthly fees of $40. The club‘s

activity of registering the customer does not transfer any service to the customer and,

therefore, is not a performance obligation. The club does have an obligation to keep the

health club open and available for use to the customer. Additionally, by not requiring that

the customer pay the membership fee again at renewal, the club is effectively providing a

discounted renewal rate to the customer. The club determines that renewal option is not

material and is not a separate performance obligation. The $150 membership fee is

allocated to the performance obligation to provide access to the health club and

recognized as revenue over the one-year contract period.

Alternatively, the club may determine the renewal option is material and is a separate

performance obligation. Based on historical experience, the club determines that its

customers, on average, renew their annual memberships two times before terminating

their relationship with the club. As a result, the club determines that the option provides

the customer the right to two annual renewals at a discounted price. In this scenario, the

club would allocate the total transaction consideration of $630 ($150 upfront membership

fee + $480 ($40 x 12 months) to the two identified performance obligations (monthly

service and renewal option) based on the relative standalone selling price method. The

amount allocated to the renewal option would be recognized as each of the two renewal

periods is either exercised or forfeited by recognizing 50% of the transaction price

allocated to the renewal option at the end of year one, and 50% at the end of year two.

This pattern of revenue recognition for this type of upfront fee is significantly different

than the pattern used under current US GAAP, in which the upfront fee would be

recognized ratably over the expected customer relationship period of three years.

Chapter 5: Allocate the transaction price to the separate performance obligations


Once the performance obligations are identified and the transaction price has been

determined, the proposed model requires an entity to allocate the transaction price to the

performance obligations in proportion to their standalone selling prices (i.e., on a relative

standalone selling price basis). Any discount within the contract is allocated proportionally to

all of the separate performance obligations in the contract.

How we see it

The required use of the relative standalone selling price basis will be a significant change in

accounting for many transactions, including those transactions that were accounted for

using the residual method (see Section 5.1 for further discussion of the residual method).

Additionally, this requirement, combined with the change in treatment of variable

consideration under the proposed model (discussed in Section 3.1), likely will have a

significant effect on those transactions in which the amount of revenue recognizable is

limited under current US GAAP due to contingencies associated with the transaction

consideration. In most of these situations, the relative standalone selling price method will

result in earlier revenue recognition.

Example 20 — relative selling price allocation

Wireless Company offers its customers a 400 minute wireless plan for $40 a month over a

2-year contract period, which is also the standalone selling price of this plan. Wireless

Company offers two handsets: a cell phone model that has been in the market for 18

months that the operator is offering for free (standalone selling price is $200) and the

newest version of the phone that includes improved features and functionality for which

the operator is charging $160 (standalone selling price is $480). For purposes of this

example, assume the standalone selling price of the 400-minute wireless plan is $40.

Customer A selects the older model cell phone, and Customer B selects the newer model.

Wireless Company does not expect any credit loss, and no rebates, incentives or other

discounts are provided.

The following table illustrates the differences in the allocation of the transaction price and

revenue recognized between current US GAAP and the proposed model:

Current US GAAP Proposed model

Customer A Customer B Customer A Customer B

Handset revenue

$ – $ 160 $ 166 $ 373

[Free — no cash received] [$160 cash received] [$200/(960+200)x960] [$480/(960+480)x1,120]

Service revenue

960 960 794 747

[$40/month x 24 months] [$40/month x 24 months] [$960/(960+200)x960] [$960/(960+480)x1,120]

Total revenue $ 960 $ 1,120 $ 960 $ 1,120




Under current US GAAP, the telecom operator is limited to recognizing revenue upon the

delivery of the handset to the amount of consideration received up front; that is, the

discounted purchase price. When the phone is provided at no charge, the telecom operator

is prevented from recognizing any revenue upon the delivery of the handset. This is because

the remaining transaction consideration generally is contingent upon the telecom operator

providing the monthly wireless service and, therefore, cannot be allocated to the first

delivered item. Conversely, under the proposed model, the total transaction consideration is

allocated to the identified deliverables (handset and monthly service) on the relative

standalone selling price, and revenue recognized is with each performance obligation as

that performance obligation is satisfied. The end result is that the telecom operator will

allocate some of the transaction consideration to the handset, and recognize that revenue

before the consideration is actually due from the customer.

5.1 Estimating standalone selling prices

Under the proposed model, the standalone selling price should represent the price an entity

would sell a good or service on a standalone basis at contract inception. When available, the

proposed model indicates the observable price of a good or service sold separately provides

the best evidence of standalone selling price. However, in many situations, standalone selling

prices will not be readily observable. In such situations, the entity must estimate the amount

for which it would sell each performance obligation on a standalone basis.

The proposed model is clear that an entity should not presume that a contractually stated

price or a list price for a good or service is representative of the standalone selling price. For

example, a vendor enters into a contract with Customer A to provide good A at $100, good B

at $75, and good C for free. In order to allocate the transaction price appropriately, the

vendor will have to determine the standalone selling prices for each of the goods and not

simply use the rates stated in the contract.

How we see it

Multiple-element transactions

The relative standalone selling price method required for allocation under the proposed

model is similar to the relative selling price method required under ASC 605-25 (after

reflecting the effects of ASU 2009-13), which provides a hierarchy to follow in determining

the standalone selling price that includes VSOE, third-party evidence (TPE) and best

estimate of selling price. While the proposed model does not specify a hierarchy, it

indicates that the use of observable inputs should be maximized. Accordingly, we would

not expect significant differences in estimated selling prices to arise between the proposed

model and the recently amended revenue recognition guidance.



However, for those entities that have not yet adopted the provisions of ASU 2009-13, it does represent a significant change from the existing guidance within ASC 605-25. Based

on experiences from early adopters of ASU 2009-13, entities may find implementing the relative standalone selling price method difficult. First, developing the estimated selling price for elements that are not typically sold separately is challenging. Second, entities are

facing information systems challenges. Certain legacy information systems do not have the functionality required to apply the relative selling price method and, as a result, many early adopters have been using spreadsheets and databases to make necessary adjustments.

Software transactions

Transactions currently accounted for under the software revenue recognition guidance will

be significantly affected by the allocation guidance. Oftentimes, VSOE of selling price does not exist for all of the elements in a software arrangement and, therefore, the use of the residual method (described in the next paragraph) is prevalent. In fact, in many situations,

VSOE does not exist for any of the undelivered elements and results in the full deferral of revenue on the delivered elements.

Under the residual method, the amount of arrangement consideration allocated to the undelivered elements is equal to the VSOE of selling price of those elements. The amount

allocated to the delivered elements is equal to the difference between the total arrangement consideration and the selling price allocated to the undelivered elements, or the ―residual‖ arrangement consideration. The use of the residual method results in the

entire discount included in the arrangement being allocated to the delivered elements. Under current US GAAP, software vendors generally apply the residual method to allocate arrangement consideration to software licenses as such licenses are rarely, if ever, sold separately (accordingly, VSOE of selling price cannot exist for the software license).

Under the proposed model, the residual method is prohibited and software vendors will be required to estimate the standalone selling price of software licenses such that the transaction price may be allocated to all of the performance obligations included in the

contract, including the software license, based on their relative standalone selling prices. Entities may find it difficult to determine the standalone selling prices of licenses as a result of the current business practices within that industry. Generally, the software license is the

element of the arrangement that reflects pricing fluctuations, while services and postcontract customer support (PCS) are priced consistently from arrangement to arrangement. Although the ED provides the flexibility to use a cost-plus approach to

estimate the standalone selling price (see below), the lack of incremental cost associated with the sale of a software license may require the exercise of greater judgment in pricing each transaction as compared to companies that sell tangible products.

Further, as described in Section 3.1 a good or service must be ―distinct‖ to be considered a

separate performance obligation. If an entity lacks the ability to identify the costs or distinguishable resources needed to provide the license, a distinct profit margin would likely not be evident for those licenses, resulting in the entity‘s inability to demonstrate that

a software license is distinct.



Example 21 — distinct goods and services

A software vendor provides a customer a non-exclusive perpetual software license and

PCS services for a term of one year, with the option to renew PCS on an annual basis. The

software vendor determines that VSOE of selling price of PCS does not exist; however,

50% of actual PCS renewals were within a narrow range of pricing. Because VSOE of selling

price does not exist, the vendor would have to defer recognition of the license fee under

current US GAAP. Under the proposed model, the software vendor‘s analysis of PCS

renewals will help support its estimate of the standalone selling price of the PCS. However,

the vendor will have to determine whether or not the software is distinct from the PCS.

If the vendor determines that the software is distinct, it would determine the estimated

standalone selling price of the software and allocate the total transaction consideration to

the two performance obligations (software and PCS) using the relative selling price

method. Once it has allocated the transaction price to each performance obligation, the

entity would determine the appropriate period over which to recognize the revenue. While

the transaction price allocated to the PCS would likely be recognized over the service

period, the entity would have to consider the terms of the software license agreement to

determine the appropriate recognition period (see Section 6.4 for further discussion).

Conversely, the entity may determine that the software is not distinct from the PCS.

This may be the case if the entity cannot identify distinguishable costs or resources

needed to provide the license from those used to provide the PCS (such as the when-and-

if-available upgrades). In such cases, the entity would conclude that the arrangement

contains only a single performance obligation and that the revenue should be recognized

over the PCS period.

If an entity determines that the software is not distinct from the PCS, and that the two

items represent a single performance obligation, the entity may also have to consider

whether any payment received relating to the license is, in fact, an up-front fee that has to

be separately evaluated under the proposed model. If the license is not a separate

performance obligation from the PCS, an entity might conclude that the customer is

receiving not only the software and PCS, but an option to renew that PCS at a discounted

rate (as the upfront license fee is not due each year). Such a conclusion would require the

entity to allocate some of the transaction price to the option, and recognize that amount

over the expected option period.



The proposed model indicates that two possible approaches to estimating standalone selling

price include the following:

► Expected cost plus a margin approach — an entity will use its expected costs of satisfying

the performance obligation and add a margin that the entity typically requires for the

provision of similar goods and services.

► Adjusted market assessment approach — an entity can examine the market in which it

regularly sells goods and services and estimate the price that customers would be willing

to pay. This approach may also include referring to quoted prices from the entity‘s

competitors, adjusted as appropriate to reflect the entity‘s own costs and margins.

The approaches discussed in the proposed model are not the only estimation methods

permitted. The proposed model does not preclude nor prescribe any particular method for

estimating standalone selling prices. Any reasonable estimation method is permitted, as long

as it is consistent with the basis of a standalone selling price, maximizes the use of observable

inputs and is applied on a consistent basis for similar goods and services and customers.

How we see it

In most instances, entities will be able to make estimates of standalone selling prices that

represent management‘s best estimate considering observable inputs. However, there may

be occasions when it is difficult for entities to determine a standalone selling price,

particularly as it relates to the selling price of certain goods or services that are never sold

independently by the entity or others (e.g., specified upgrade rights for software

companies). In these situations, under the proposed model entities still will be required to

make an estimate of the standalone selling price, and may look to the underlying costs or

the target margins for the product. With the exception of those entities that have already

adopted the provisions of ASU 2009-13, which modified ASC 605-25, this will be a

significant change from current practice. This change may require the involvement of

personnel that have not traditionally been involved in determining whether items included

in a multiple-element arrangement can be accounted for separately, such as operating

personnel involved in an entity‘s pricing decisions.

While the proposed guidance seems to indicate that an entity can use either an expected

cost plus a margin approach or an adjusted market approach, we believe that an entity

actually will have to consider both of these approaches in coming up with their estimate of

a standalone selling price. That is, an entity could not determine that the expected cost

plus a margin represents a reasonable standalone selling price if the market would not

support the amount of margin used by the entity.



Example 22 — estimated selling price

Manufacturing Co. enters into a contract with a customer to sell a machine for $100,000.

The total contract price includes installation of the machine and a two-year warranty.

Manufacturing Co. routinely sells the machine for $75,000 on a standalone basis without

installation or warranty provisions. While Manufacturing Co. rarely provides installation

services separate from the sale of the machines, it is aware that other companies in the

marketplace provide this service, charging $10,000 to $15,000 for each installation.

Manufacturing Co. does not sell warranties separately, nor does anyone else in the

marketplace sell a similar warranty. However, given the length of the warranty,

management has concluded that the objective of the warranty is to cover problems arising

after the machinery is shipped and installed for the customer and, therefore, represents a

separate performance obligation.

In this example, Manufacturing Co. regularly sells the machine on its own and therefore

has evidence of a standalone selling price of $75,000. Management concludes they will

use an adjusted market assessment approach for the installation services using the

competitors‘ mid-point pricing of $12,500, adjusted for Manufacturing Co.‘s cost structure

and expected margin, resulting in an estimated selling price of $14,000. Lastly, the

warranty services are priced based on Manufacturing Co.‘s estimated cost plus a margin,

taking into consideration the amount of margin the market will bear. This estimate results

in a standalone selling price of $20,000 for the warranty.

The aggregate individual standalone selling price ($109,000) exceeds the total transaction

price and must be allocated based on the relative standalone selling price of each

performance obligation. Therefore, the amount of the $100,000 transaction price is

allocated to each performance obligation as follows:

► • Machine — $68,800 ($75,000 × ($100,000/$109,000))

► • Installation — $12,850 ($14,000 × ($100,000/$109,000))

► • Warranty — $18,350 ($20,000 × ($100,000/$109,000))

The entity would recognize revenue as each performance obligation is satisfied in the

amount allocated to that performance obligation at contract inception.

5.2 Changes in transaction price subsequent to contract inception

Under the proposed model, the standalone selling price is determined only at contract

inception. While the amounts allocated to performance obligations are updated to reflect

changes in the estimated transaction price as goods and services are delivered, the

standalone selling prices used to perform the allocation are not updated to reflect changes in

the standalone selling prices after contract inception.



Example 23 — Changes in transaction price

Continuing Example 22 above for Manufacturing Co., assume that after Manufacturing Co.

delivers the machine, the customer is not happy with the performance of the machine and

requests a price reduction of $10,000. Additionally, as a result of the performance issues

highlighted by the customer, Manufacturing Co. estimates its costs to satisfy the warranty

obligation will increase by 15%.

Manufacturing Co. agrees to reduce the price of the transaction by 10%, and must re-

perform the relative selling price allocation, allocating the revised transaction price of

$90,000 to the three performance obligations in the arrangement. However, in doing this

re-allocation, Manufacturing Co. does not update the original standalone selling prices,

despite the expected change in costs associated with the warranty obligation. Therefore,

the amount of the $90,000 transaction price is reallocated to each performance obligation

as follows:

► Machine — $61,926 ($75,000× ($90,000/$109,000))

► Installation — $11,560 ($14,000× ($90,000/$109,000))

► Warranty— $16,514 ($20,000 × ($90,000/$109,000))

Chapter 6: Satisfaction of performance obligations


Under the proposed model, an entity recognizes revenue only when an identified

performance obligation is satisfied by transferring a promised good or service to a customer.

A good or service is generally considered to be transferred when the customer obtains

control, which the proposed guidance defines as ―an entity‘s ability to direct the use of, and

receive the benefit from, the good or service.‖ Control would also include the ability to

prevent other entities from directing the use of, and receiving the benefit from, a good or

service. For purposes of applying the proposed model, the transfer of control to the customer

represents the transfer of all rights with regard to the good or service. Upon transferring

control, the customer has sole possession of the right to use the good or service for the

remainder of its economic life or to consume the good or service in its own operations. The

customer‘s ability to receive the benefit from the good or service is represented by its right to

substantially all of the cash inflows, or the reduction of cash outflows, generated by the

goods or services.

Certain transactions are structured so that the selling entity retains a security interest in the

goods subject to the sales contract. For example, a selling entity often retains certain rights

(e.g., legal title) to goods provided to a customer as protection against the customer‘s failure

to pay for the goods. The ED concludes that such rights are protective rights that do not

preclude the customer from obtaining ―control‖ as described in the proposed guidance.

In many situations, the determination of when the customer obtains control is relatively

straightforward. However, in other circumstances this determination is more complex. In an

effort to help entities determine whether a customer has obtained control of a particular

good or service, the Boards have provided certain indicators in Paragraph 20 of the ED.

Excerpt from the ED

30. An entity shall assess the transfer of control of goods or services for each separate

performance obligation. Indicators that the customer has obtained control of a good or

service include the following:

(a) the customer has an unconditional obligation to pay — if a customer is

unconditionally obliged to pay for a good or service, typically that is because the

customer has obtained control of the good or service in exchange. An obligation to

pay is unconditional when nothing other than the passage of time is required

before payment is due.

(b) the customer has legal title — legal title often indicates which party has the ability

to direct the use of, and receive the benefit from, a good. Benefits of legal title

include the ability to sell a good, exchange it for another asset or use it to secure or

settle debt. Hence, the transfer of legal title often coincides with the transfer of

control. However, in some cases, possession of legal title is a protective right and

may not coincide with the transfer of control to a customer.




(c) the customer has physical possession — in many cases, physical possession of a

good gives the customer the ability to direct the use of that good. In some cases,

however, physical possession does not coincide with control of a good. For

example, in some consignment and sale and repurchase arrangements, an entity

may have transferred physical possession but retained control of a good.

Conversely, in some bill-and-hold arrangements, the entity may have physical

possession of a good that the customer controls.

(d) the design or function of the good or service is customer-specific — a good or

service with a customer-specific design or function might be of little value to an

entity because the good or service lacks an alternative use. For instance, if an

entity cannot sell a customer-specific asset to another customer, it is likely that the

entity would require the customer to obtain control of the asset (and pay for any

work completed to date) as it is created. A customer‘s ability to specify only minor

changes to the design or function of a good or service or to choose from a range of

standardized options specified by the entity typically would not indicate a

customer-specific good or service. However, a customer‘s ability to specify major

changes to the design or function of the good or service would indicate that a

customer obtains control of the asset as it is created.

The ED acknowledges that some of the indicators may not be relevant to certain transactions.

Additionally, none of the indicators are meant to be individually determinative of whether the

customer has gained control of the good or service.

Revenue is recognized when control of a promised good or service has been transferred to

the customer. For example, if the arrangement involves a promised good (except for certain

customized goods), the entity likely would recognize revenue once the good is transferred to

the customer. Alternatively, if the arrangement involves services, the related revenue likely

would be recognized as the services are provided (based on the notion that control over

those services transfers continuously). These concepts are explored further in the following

sections that discuss some of the complicating terms and conditions prevalent in many

arrangements.

How we see it

Existing US GAAP generally considers the transfer of the risks and rewards of ownership

when determining whether an asset has been transferred (and, thus, when revenue is

recognized). This concept is based on how the seller and the customer share both the

potential gain (the reward) and the potential loss (risk) associated with owning a product.



The use of a revenue recognition approach based on the risks and rewards of ownership

may often yield similar results to an approach based on control because the party

controlling an asset often has substantially all of the risks and rewards associated with that

asset. However, the Boards concluded that a control approach was the most appropriate

approach for recognizing revenue. In the Boards‘ view, the transfer of goods and services

can be more consistently evaluated when considering control because it can be difficult to

judge whether the preponderance of the risks and rewards have been transferred when the

seller retains some risks and rewards. For example, any risks or rewards retained by a

seller may represent a separate performance obligation under the concept of control

(i.e., a portion of the revenue may be recognized on satisfied performance obligations

apart from the retained risks and rewards). Considering the risks and rewards of

ownership, however, may lead an entity to conclude a single performance obligation exists

that is not satisfied until the risks and rewards are transferred to the customer. This

approach is similar to the control concept used to determine when a financial asset has

been transferred under the guidance for transfers of financial assets in ASC 860.

6.1 Continuous transfer of goods and services

Services arrangements and certain other supply or long-term contracting agreements may

provide for the continuous delivery of goods or services over the course of the contract

period. In many circumstances, the four indicators provided by the Boards (discussed directly

above) to help determine when control has transferred will be evident in situations in which

an entity determines that control transfers continuously.

Example 24 — continuous transfer of control

An entity enters into an agreement to provide for the design and construction of a

specialized piece of equipment. During the design phase, the entity works extensively with

the customer to configure the customized equipment to the customer‘s wishes. The

customer obtains control of the equipment as it is constructed, and makes non-refundable

payments to the entity. In this scenario, the entity determines it has two performance

obligations, the design services and the construction services. Further, the entity

determines that control over both of these obligations transfers continuously.

If the entity is unable to demonstrate that control transfers continuously, the presumption is

that the contract is to provide a completed asset to the customer, in which case revenue is

recognized when control of the completed asset is transferred (generally upon delivery of the

completed asset).



When it has been determined that control transfers continuously, the proposed guidance

requires that the entity select a single revenue recognition method for the relevant

performance obligation that best depicts this continuous transfer. The performance

obligation would be accounted for under the selected method until it has been fully satisfied.

The proposed guidance also states that the selected method is applied to similar

arrangements containing similar performance obligations.

Paragraph 33 in the ED provides three methods for recognizing revenue on arrangements

involving the continuous transfer of goods and services.

Excerpt from the ED

33. Suitable methods of recognizing revenue to depict the continuous transfer of goods or

services to the customer include the following:

(a) output methods that recognize revenue on the basis of units produced or

delivered, contract milestones, or surveys of goods or services transferred to date

relative to the total goods or services to be transferred. Output methods often

result in the most faithful depiction of the transfer of goods or services. However,

other methods may also provide a faithful depiction but at a lower cost.

(b) input methods that recognize revenue on the basis of efforts expended to date (for

example, costs of resources consumed, labor hours expended, and machine hours

used) relative to total efforts expected to be expended. Inputs often are more

directly observable than outputs. However, a significant drawback of input

methods is that there may not be a direct relationship between the efforts

expended and the transfer of goods or services because of deficiencies in the

entity‘s performance or other factors. When using an input method, an entity shall

exclude the effects of any inputs that do not depict the transfer of goods or

services to the customer (for example, the costs of abnormal amounts of wasted

materials, labor, or other resources to fulfill the contract).

(c) methods based on the passage of time. An entity would recognize revenue on a

straight-line basis over the expected duration of the contract if services are

transferred evenly over time.

How we see it

We expect the proposed standard to have a significant impact on some entities that enter

into arrangements to provide goods and services over time. In particular, entities engaged

in construction, software development and other similar activities may see significant

changes in the timing and amount of revenue recognition based on the terms of the

contracts underlying each transaction.



Example 25 — changes from current practice even when control transfers continuously

Entity G enters into contracts to provide its customer 10 vessels and currently uses a

percentage-of-completion method based on a cost-to-cost measure under ASC 605-35.

That is, it recognizes revenue at each reporting period based on the ratio of costs incurred

to date compared to total costs expected under the contract. However, under the proposed

model, Entity G determines that each of the vessels represents a separate performance

obligation within the contract, and that control over each vessel is transferred as the entity

transfers the vessel to the customer. As a result, Entity G would recognize revenue only as

it delivers each unit, rather than continuously as it would under current US GAAP. For

example, assume at 31 December, the entity believed the contract was 47% complete

based on the costs incurred to date. However, at that point in time, the entity had only

delivered 4 of the 10 vessels. Under current US GAAP, the entity would have recognized

47% of the transaction price as revenue, based on the proportion of costs incurred to date

to total expected costs to construct the vessels. Under the proposed model, the entity

would have recognized only 40% of the total transaction price as revenue.

Further, entities currently using a percentage-of-completion method may determine that

control over certain performance obligations within the contract are transferred at a point

in time (rather than over a period of time) while control over other performance

obligations within the contract are transferred continuously over time. Conversely, under

current US GAAP, once a contract qualifies for the use of the percentage-of-completion

method, generally the entire contract is accounted for under that method.

Example 26 — only certain goods and services within an arrangement are transferred

continuously

Software Co. enters into an arrangement to provide its customer hardware, customized

software and ongoing support services. In analyzing the arrangement, Software Co.

determines that the hardware, customized software and ongoing support each represent

separate performance obligations. Further, the entity concludes that the control of the

hardware transfers at the time Software Co. physically delivers the product. However, due

to the extensive customization efforts, the control over the software transfers

continuously. Finally, the control over the ongoing support services also transfers

continuously. Under the proposed model, revenue for the hardware is recognized upon

delivery, while revenue for the other performance obligations is recognized continuously

over the performance period. Under current GAAP, the entire arrangement would be

accounted for under the percentage-of-completion approach, and revenue would be

recognized over the performance period in proportion to the costs incurred. This could

result in a materially different pattern of revenue recognition compared to the proposed

model, particularly for the hardware.



6.2 Recognizing revenue when a right of return exists

As discussed in Section 3.6, the ED concludes that a right of return does not represent a

separate performance obligation. Instead, the existence of a right of return affects the

amount of revenue an entity can recognize for transferred performance obligations, as the

entity must determine whether the customer will return the transferred product.

Similar to the accounting for variable consideration discussed in Section 4.1, if returns are

reasonably estimable, the entity estimates the transaction price based on the probability-

weighted amount of the consideration the entity expects to retain through the end of the

return period. The amount of expected returns is recognized as a refund liability, representing

the entity‘s obligation to return the customer‘s consideration for expected failed sales. If the

entity is unable to estimate the probability of returns, revenue is not recognized until that

probability can be reasonably estimated, which may be at the end of the return period.

An entity must remeasure refund liabilities, once established, at each financial reporting date

for changes in assumptions regarding expected returns. Any adjustments made to the

estimate would result in a corresponding adjustment to amounts allocated to the satisfied

performance obligations (e.g., if the entity expects the number of returns to be higher than

originally estimated, it would have to decrease the amount of revenue recognized and

increase the refund liability).

Finally, when customers exercise their rights of return, the entity may receive the returned

product in saleable or reparable condition. Under the proposed guidance, when the initial sale

is recognized as revenue, the entity also recognizes an asset separate from inventory (and

adjusts cost of sales) for its right to recover the goods returned by the customer. The asset is

initially measured at the former carrying amount of the inventory less any expected costs to

recover the goods. Along with remeasuring the refund liability at each financial reporting

date, the entity would update the measurement of the asset recorded for any revisions to its

expected level of returns. Additionally, the asset recorded is subject to impairment.

Example 27 — sale of a product with a right of return

Pharma sells 1,000 units of Product A to Distributor for $100 each. Payment is due to

Pharma 30 days after the units are transferred to Distributor. Pharma allows its customers

to return Product A six months prior to or six months after the designated expiration date

for a full refund. The cost of each unit is $50.

Pharma estimates, based on a probability-weighted average calculation, that 4% of sales of

Product A will be returned by the customer for a full refund. Therefore, 4% of the sale to

Distributor would be recognized as a refund liability rather than revenue (4% x (1,000 units

x $100) = $4,000).



Upon the transfer of control of Product A, Pharma would record the following entries:

Dr. Accounts receivable 100,000

Cr. Revenue 96,000

Cr. Refund liability 4,000

To record revenue and the refund liability

Dr. Cost of sales 48,000

Dr. Return asset 2,000

Cr. Inventory 50,000

To record the cost of sales, relief of inventory and the return right

Subsequent to the initial transfer of Product A, Pharma determines that it now expects

Distributor to return 5% of the units of Product A rather than the 4% originally estimated.

Because changes in estimated returns are recognized as an adjustment to revenue and

cost of sales, with corresponding recognition of a refund liability and return asset, the

following entries would be recorded:

Dr. Revenue 1,000 [(5% - 4%) x (1,000 units x $100)]

Cr. Refund liability 1,000

To adjust refund liability for change in estimated returns

Dr. Return asset 500 [(5% - 4%) x (1,000 units x $50 cost)]

Cr. Cost of sales 500

To adjust return asset for change in estimated returns

However, to the extent Pharma determines that any drug returns are likely to have

diminished value, it also would recognize an impairment on the recorded return asset.

How we see it

While the accounting for rights of return should not be a significant shift from current

practice, there are some notable differences. Current US GAAP is similar to the proposed

guidance with the main difference being the accounting for the right of return asset. Under

current US GAAP, the carrying value associated with any product expected to be returned

typically remains in inventory, whereas the proposed guidance requires the asset to be

recorded separate from inventory to provide greater transparency. Additionally, the

proposed model is clear that the carrying value of the return asset (i.e., product expected

to be returned) is subject to impairment testing on its own, separate from other inventory

on hand. Under current US GAAP, as expected returns remain within inventory, they are

not subject to separate impairment testing.



6.3 Repurchase agreements

Certain agreements executed by entities include repurchase provisions, either as a

component of a sales contract or as a separate contract that relates to the same or similar

goods in the original agreement. The ED addresses whether a customer has obtained control

of an asset in arrangements containing such repurchase provisions. Paragraph 48 of the ED

identifies three main forms of these provisions:

1. A customer‘s unconditional right to require the selling entity to repurchase the asset

(essentially a written put option)

2. An entity‘s unconditional obligation to repurchase the asset in the original contract

(essentially a forward contract)

3. An entity‘s unconditional right to repurchase the asset in the original contract (essentially

a purchased call option)

6.3.1 Written put option held by the customer

The proposed model indicates that if the customer has the ability to require the entity to

repurchase the asset, the customer has obtained control of the asset (i.e., the customer has

the ability to direct the use of the asset) and a sale should be recorded. These arrangements

should be treated essentially the same as a sale with the right of return (discussed in Sections

3.6 and 6.2). Therefore, upon recognizing the sale, the entity also would recognize a liability

for the expected returns, and an asset for product expected to be returned. The ED

acknowledges that there may be situations in which the entity is certain that the customer will

exercise its option to repurchase the asset (e.g., it would be economically disadvantageous to

the customer to not exercise the put option). In such situations, the selling entity would

record a repurchase liability for substantially the full amount of the consideration received

from the customer, adjusted for the time value of money, essentially assuming that all the

products will be returned.

6.3.2 Forward or call option held by the entity

Conversely, if the entity has an unconditional obligation or right to repurchase the asset, the

customer has not obtained control of the asset because it is constrained in its ability to direct

the use of the asset. Therefore, the transaction likely represents a lease or a financing

transaction rather than a sale. The proposed guidance indicates that if the entity is obligated

or has the right to repurchase the asset at a price less than the original sales price, the entity

accounts for the transaction as a lease. If the entity is obligated or has the right to

repurchase the asset at a price equal to or greater than the original sales price, the

arrangement is accounted for as a financing. In the case of a financing arrangement, the

selling entity continues to recognize the asset and records a financial liability for the

consideration received from the customer. The difference between the consideration

received from and the consideration paid to the customer upon repurchase represents the

interest and holding costs, as applicable, that are recognized over the term of the financing.



Because the proposed model does not consider the likelihood of exercise of a call option held

by the entity in determining the accounting treatment, we believe the potential exists for

counterintuitive accounting results. For example, in certain transactions, an entity may have

an unconditional right to repurchase an asset at an amount greater than the original sales

price. The proposed model will require the entity to account for all such transactions as a

financing, even in situations in which it is highly unlikely the entity will exercise the call option.

Example 29 — vendor obligation to repurchase a good at a price greater than the original

sales price (i.e., forward)

Can manufacturer enters into an agreement to sell a customer aluminum ingots. As part of

the agreement, Can manufacturer also agrees to repurchase the ingots in 60 days at the

original sales price plus 2%. As Can manufacturer has an unconditional obligation to

repurchase the ingots at an amount greater than the original sales price, this transaction is

treated as a financing under the proposed model. If the selling price of the ingots was

$200,000, Can manufacturer would records the following entry when it receives the

consideration from the customer:

Dr. Cash 200,000

Cr. Financial liability 200,000

Further, since the entity has to pay $204,000 ($200,000 x1.02) to repurchase the ingots,

the entity would recognize the $4,000 differential as interest and holding costs over the

60-day period.

Example 30 — vendor obligation to repurchase a good at a price less than the original

sales price (i.e., forward)

A manufacturer of lift equipment enters into an agreement to sell six scissor lifts to a

customer. As part of that agreement, the manufacturer agrees to repurchase the

equipment from the customer in three years at 70% of the original purchase price. Since

the entity has an unconditional obligation to repurchase the assets at a price less than the

original purchase price, the proposed model requires this transaction be accounted for as a

lease. Under the current lease model (ASC 840), assuming the transaction is accounted for

as an operating lease, the initial payment would be recognized as a liability and lease

revenue (the difference between the initial purchase price and the repurchase price) would

be recognized ratably over the three-year lease period. Additionally, the asset remains on

the lessor‘s statement of financial position and is depreciated over its estimated useful life.



How we see it

The proposed guidance does not differ significantly from the existing treatment of

repurchase agreements under ASC 470-4010 for most transactions; however, entities that

retain an option to repurchase a good from the buyer as a part of sales contracts may see a

change in practice. One of the criterion under ASC 470-40 that results in accounting for a

transaction as a financing arrangement (not a sale) is that a seller‘s option to repurchase a

product contains a significant incentive or economic compulsion for the seller to exercise

the option. For example, an arrangement that includes a significant penalty if the seller

does not exercise the option may fit this criterion would meet this condition. This model

differs from the proposed guidance, which provides that any seller option to repurchase

the product indicates that the buyer does not have control of the product because it is

constrained in its ability to direct its use. Accordingly, while not all seller options to

repurchase results in accounting for the transactions as a financing under current US

GAAP, such options would result in accounting for all such transactions as financing under

the proposed model.

6.4 Licensing and rights to use

Granting licenses and rights to use are common in the software, media and entertainment,

life sciences and many other industries. A license granted to a customer represents the

customer‘s right to use the intellectual property (IP) developed or owned by the entity for its

intended use. Paragraph IG31 of the ED provides the following examples of intellectual

property:

► Software and technology

► Motion pictures, music and other forms of media and entertainment

► Franchises

► Patents, trademarks and copyrights

► Other intangible assets

The proposed guidance for licenses and other rights of use (collectively, licenses) requires an

analysis of the customer‘s rights to determine the appropriate accounting treatment. The ED

provides that if a customer (licensee) obtains control of substantially all of the rights

associated with the entity‘s (licensor‘s) intellectual property, the arrangement is considered a

sale as opposed to a right to use the IP. For example, under the proposed guidance if a

licensor grants the licensee the exclusive right to use the IP for substantially all of the IP‘s

economic life, the licensee is deemed to have obtained control of substantially all of the rights

associated with the IP.

10 ASC 470-40, Product Financing Arrangements



When a licensee does not obtain control of substantially all of the rights associated with the IP

(e.g., the right to use the IP is for a defined period of time that is less than the economic life

of the IP), the transaction can be treated in one of two ways.

If the licensor grants rights that are not exclusive, the right to use is generally a single

performance obligation that is satisfied when the customer is able to use those rights. Rights

of use are considered to be non-exclusive if the licensor is able to grant similar rights to other

parties using substantially equal terms. For example, this occurs frequently in the software

industry in which software developers sell software licenses to a number of customers with

substantially the same terms.

Conversely, if the licensor has granted exclusive rights of use to the licensee, the licensor

would be unable to grant a similar right to any other party at the same time, indicating that

the licensor‘s ability to control the IP is constrained during the license period. The Boards

concluded that this constraint suggests that the licensor has a performance obligation that

will not be fully satisfied until the end of the license period. The licensor‘s performance

obligation, therefore, would be satisfied continuously over the course of the licensing period.

Immediate recognition of revenue may also be precluded upon granting rights of use to more

than one party if some parties obtain rights that differ substantially from the rights obtained

by others. This is an indication that each party was granted exclusive rights under their

respective arrangements and for which revenue would be recognized over the license period.

Paragraph IG37 of the ED describes example bases of exclusivity.

Excerpt from the ED

IG37. An entity might grant rights to more than one customer to use the same intellectual

property. However, the rights of one customer might substantially differ from the

rights granted to another customer. Hence, those rights would be exclusive. An entity

might grant exclusive rights on the basis of the following:

(a) time — for example, a motion picture studio granting one customer the exclusive

right to air a television series during one time period and granting another

customer the exclusive right to air the same series during another time period;

(b) geography — for example, a franchisor granting one customer the exclusive right to

a franchise in a particular region and granting another customer the exclusive right

to the franchise in a different region;

(c) distribution channel or medium — for example, a record label granting one customer

the exclusive right to distribute a soundtrack on compact disc and granting another

customer the exclusive right to distribute the soundtrack via the internet.



How we see it

Current US GAAP for rights of use differs by industry, typically addressing only specific

types of transactions and leaving many transactions and entities with no specific guidance.

Entities without specific guidance generally analogize to the industry-specific guidance that

most closely resembles the transaction type. The analogy to specific accounting literature

is fairly clear for some types of intellectual property. For example, intellectual property

that is primarily composed of content, such as a book or magazine, arguably is similar to a

film, and a publisher might conclude that an analogy to the guidance of ASC 92611 may be

most appropriate. However, in many cases an analogy to specific accounting literature is

not clear, which leads to differences in practice. The proposed guidance solves this issue by

proposing a single model applicable to all licensing transactions and provides guidance for

those transactions for which specific guidance historically has not existed.

However, the proposed model in the ED presents a significant change in practice for the

recognition of revenue for transfers of intellectual property rights that contain exclusivity

clauses. For example, those entities in the media and entertainment field that grant

exclusive licenses to intellectual property for a defined period of time or in a specific

geography will likely be required to account for the revenue earned over the term of the

license period. Currently, those entities are able to account for such revenue upon delivery

(assuming all other revenue recognition criteria are met).

6.5 Bill-and-hold arrangements

Certain sales transactions may result in the selling entity fulfilling its obligations under the

sales contract and billing the customer for the work performed but not shipping the goods until

a later date. These transactions are referred to as ―bill-and-hold‖ transactions. Bill-and-hold

transactions are usually designed as such at the request of the purchaser for a number of

reasons, including a lack of storage capacity or delays in its ability to use the goods.

Under the proposed model, the selling entity must evaluate whether the customer has obtained

control of the goods in order to determine the performance obligation has been satisfied and to

recognize the related revenue. As the customer has not taken possession of the goods in a bill-

and-hold transaction, the proposed guidance includes the following criteria that must be met

for a customer to have obtained control of a product in a bill-and-hold arrangement:

► The customer must have requested the contract to be on a bill-and-hold basis

► The product must be identified separately as the customer‘s

► The product currently must be ready for delivery at the location and time specified, or to

be specified, by the customer

► The entity cannot use the product or sell it to another customer

11 ASC 926, Entertainment — Films



If the above conditions are met, the selling entity is no longer able to direct the use of the

goods, but instead acts as a custodian for the customer and the performance obligation has

been satisfied. In that case, however, the selling entity must consider whether custodial

services are a material separate performance obligation for which a portion of the

transaction price would be allocated and recognized as revenue during the custodial period.

How we see it

The criteria for determining whether a bill-and-hold transaction qualifies for revenue

recognition under the proposed guidance are similar to, but somewhat less detailed than,

the criteria established in SAB Topic 13 that govern accounting for bill-and-hold

transactions today. Because the general principles within the proposed model are similar to

current guidance, we expect that most bill and hold transactions that would qualify for

revenue recognition under current US GAAP will also qualify for revenue recognition under

the proposed model.

6.6 Customer acceptance

Certain sales contracts include customer acceptance clauses specifying that the customer

must approve (accept) the goods before the customer becomes obligated to pay. These

clauses may be straightforward and simply provide a customer the ability to accept or reject

the delivered goods based on objective criteria specified in the contract (e.g., the goods

function at a specified speed) or may be more subjective in nature. The determination of

whether the customer has obtained control of the good or service must consider any

customer acceptance clauses in the agreement because without satisfying the customer

acceptance clauses in the contract, the entity may not be entitled to consideration, or may be

required to take remedial action before it has satisfied its performance obligations.

The proposed model states that if an entity can objectively determine that a good or service

has been transferred to the customer in accordance with the agreed specifications in the

contract, then customer acceptance is a formality that would not affect an entity‘s

determination of when the customer has obtained control of the good or service.

Contractually specified height, weight or other measurements are examples of customer

acceptance requirements that would be objectively determinable. Conversely, if the entity is

unable to objectively determine that the good or service meets the contractual specifications,

then it would be unable to conclude that the customer has obtained control before the

customer‘s acceptance of the goods. A clause that allows the customers to visually inspect,

test and apply judgment in determining whether a particular good is suitable may represent a

customer acceptance criterion that is not objectively determinable.



How we see it

The proposed guidance for accounting for customer acceptance provisions does not vary

significantly from the relevant guidance provided in SAB Topic 13 applicable today. Under

the proposed model, acceptance clauses that create uncertainty about the customer‘s

acceptance of delivered products should still be presumed to be substantive elements of an

arrangement that generally will preclude revenue recognition until formal customer sign-

off is obtained, or the acceptance provisions lapse. Determining when a vendor may

recognize revenue for an arrangement including customer-specified acceptance criteria

prior to obtaining formal customer signoff requires the use of professional judgment and

depends on the weight of the evidence in the particular circumstances.

Chapter 7: Other measurement and recognition topics


7.1 Onerous performance obligations

The proposed model requires that an entity recognize a liability and a corresponding expense

when any performance obligation becomes onerous. Under the proposed model, a

performance obligation is deemed onerous when the present value of the probability-

weighted expected direct costs of fulfilling the performance obligation are greater than the

amount of the transaction price allocated to the performance obligation. (While the proposed

model is silent on the appropriate discount rate to use in performing this calculation, we

believe using an entity-specific discount rate is appropriate since the measure is only the

entity‘s cash outflows and unrelated to the counterparty.) In making this assessment, the

proposed model is clear that the measurement should consider only direct costs incurred in

connection with the individual performance obligation. Consistent with the guidance on

contract costs (see Section 7.2), direct costs would include direct labor, direct materials,

allocated costs that relate directly to the performance obligation‘s activities

(e.g., depreciation), costs explicitly chargeable to the customer based on the contract terms

and other costs incurred only because the entity entered into the contact with the customer.

The proposed guidance requires the assessment of potential onerous performance

obligations be performed for each performance obligation within a contract, rather than for

the contract as a whole. This could result in liabilities recorded for onerous performance

obligations when the overall contract is expected to remain profitable. The Boards

acknowledge this issue and concluded it is consistent with the proposed model‘s objective to

reveal different margins on different parts of the contract. Those different margins are

revealed by identifying separate performance obligations and consequently the same unit of

account should apply to test whether those separate performance obligations are onerous.

The proposed guidance also explains that, before recognizing a liability for an onerous

performance obligation, the entity is required to determine whether any impairment exists

for the assets related to the contracts (e.g., inventory, engineering) and recognize any

impairment loss that has occurred.

Once the entity has recorded a liability and corresponding expense for an onerous

performance obligation, the proposed guidance requires that the measurement of the

obligation be updated at each financial reporting date to include changes in assumptions or

new information. Changes in the measurement of the liability are recorded as an increase or

decrease in expense in that period (note that the liability could never become negative; that

is, an asset). Upon satisfaction of the onerous performance obligation, the entity would

recognize the corresponding income as a reduction in expense.




How we see it

In principle, the notion of recognizing a liability and corresponding expense for onerous

performance obligations is not a significant change in practice for entities that follow the

construction-type and production-type contracting guidance in ASC 605-35. That guidance

requires the recognition of the entire anticipated loss as soon as the loss becomes

apparent (generally, when estimates of the total contract costs and contract revenue

indicate a loss). However, this proposed guidance likely represents a significant change for

most other transactions. Under current US GAAP, while there is diversity in practice, many

companies do not recognize losses on executory contracts unless there is specific guidance

that requires such losses to be recognized (such as the guidance in ASC 605-35).

The measurement of the amount of loss to be recognized under the proposed model differs

from current US GAAP. The current measurement of an expected loss generally is done at

the contract level, not the performance obligation level. Additionally, the proposed model

requires that the measurement consider the present value amount of probability-weighted

costs relating directly to the satisfaction of the performance obligation, while current US

GAAP requires the consideration of the current estimate of total contract costs. As a

result, the requirements to calculate the present value of future expected costs, to

probability-weight those costs, and to include only those costs that relate directly to the

satisfaction of the performance obligation (see below for a further discussion of costs) all

represent changes from current practice.

Further, the approach outlined in the proposed model indicates that the ―direct costs‖ to

be included in the calculation determining whether a performance obligation is onerous

include allocated costs that relate directly to satisfying the performance obligation. Since

the costs to be included in the calculation are not limited to incremental costs, this

approach potentially will result in recognizing liabilities for onerous performance

obligations for obligations that are expected to increase the net income of the entity. The

following example illustrates this effect.

Example 31 — onerous contract increases profitability of entity

A contractor enters into a long-term arrangement to build a new section of highway for a

state. While the contractor frequently performs this type of construction, it is the first time

it has entered into an agreement with the particular state. As a result, the contractor bid

the arrangement at close to break even in an attempt to gain future business with this

government. Due to early cost overruns, the contractor is concerned that the contract

may become onerous, and performs the required assessment. Based on the contractor‘s

calculation, the contractor determines that the present value of the expected direct costs

exceed the transaction consideration by $40,000.



As required under the proposed model, in identifying all of the direct costs incurred and

expected to be incurred, the contractor included the depreciation cost associated with the

equipment needed to perform the job, which is expected to total $80,000 during the

construction period. (The construction of a highway requires a significant amount of

equipment, all of which the contractor already possesses as a result of frequently

performing this type of work.)

However, as the contractor already owns this equipment, these costs are fixed costs of the

entity. Said another way, had the contractor not entered into this particular agreement,

the contractor would still be incurring the depreciation costs. As a result, fulfilling this

arrangement will actually improve the net income of the contractor as the contract will

allow the entity to recover at least some of its direct costs. That is, the contractor will incur

a loss of $40,000 as a result of fulfilling the contract compared to a loss of $80,000 if the

contract had not been entered into.

How we see it

The recognition of losses at the performance obligation level could result in ―day one‖ losses

being recorded on a contract. This may occur when an entity includes one or more low-

margin products in a contract with multiple goods and services or when an entity finds a low-

margin or loss contract acceptable based on some other continuing customer relationship.

For example, a printer manufacturer may be willing to accept losses on printer sales when

the manufacturer is assured that continuing printer cartridge sales will be highly profitable.

Example 32 — occurrence of a ―day one‖ loss

Company A is a calendar year-end IT consulting company that advises clients on process

management. Occasionally, Company A‘s clients request that Company A acquire any

necessary hardware on their behalf as a matter of convenience, which Company A then

sells to the clients with very little margin. On 30 November, Company A negotiates a

contract with Company B to provide consulting services and agrees to provide the

recommended hardware, all by 1 February. The contract requires Company A to provide

two consulting services plus hardware for a total transaction price of $360,000. The

allocation of the transaction price is as follows:

Performance Standalone Allocated

Obligation Cost Selling Price Transaction Price Margin

(relative selling price)

Hardware $ 200,000 $ 210,000 $ 180,000 $ (20,000)

Consulting Service 1 70,000 105,000 90,000 20,000

Consulting Service 2 60,000 105,000 90,000 30,000

$ 330,000 $ 420,000 $ 360,000 $ 30,000



Although the contract is a profitable contract, the performance obligation related to the

delivery of hardware is in a loss position at inception. Based on the relative standalone

selling price, the portion of the transaction price allocated to the hardware is less than the

cost of the hardware, indicating the performance obligation is onerous. Company A would

record an onerous performance obligation of $20,000 and record a corresponding cost of

sales for the same amount. At 31 December, Company A would remeasure the onerous

performance obligation to account for changes in assumptions or new information (e.g., an

increase in the cost of the hardware). Upon satisfying the performance obligation related to

the delivery of hardware, Company A would record revenue of $180,000, costs of sales of

$180,000 ($20,000 was previously recorded to cost of sales) and relieve the onerous

performance obligation of $20,000. Upon satisfying the performance obligations related to

the two consulting projects, Company A would record revenue of $180,000 ($90,000 each).

How we see it

In addition to the occurrence of ―day one‖ losses in multiple-element arrangements that

are profitable as a whole, the application of the proposed guidance on onerous

performance obligations may lead to ―day one‖ losses in industries with flexible pricing

models. For example, airlines commonly sell tickets on available seats at high margins for

particular classes of travelers (e.g., first-class passengers, walk-up passengers) but also sell

tickets at very low margins or at a loss. These low-margin or loss tickets are intended to

cover a portion of the fixed costs of transporting passengers. The overall profitability on

passenger contracts is supported by the high-margin ticket sales. In applying the proposed

guidance as written, the airline would be required to record a loss on the date of sale

related to any ticket sale that represents an onerous contract, even though the actual flight

is expected to result in incremental profit to the airline.

7.2 Contract costs

In addition to the proposed revenue model, the ED also provides guidance for accounting for

an entity‘s costs incurred in obtaining and fulfilling a contract to provide goods and services

to customers. This guidance is applicable for both contracts obtained and contracts under

negotiation. This differs from the revenue recognition guidance, which is applicable only once

an entity has obtained a contract.

The ED differentiates between costs that give rise to an asset and costs that should be

expensed as incurred. Under the proposed model, costs incurred that do not give rise to an

asset eligible for capitalization in accordance with other authoritative guidance

(e.g., inventory, property, plant and equipment, software) may be capitalized if the costs

meet all of the following criteria:

► The costs relate directly to the contract (or a specific contract under negotiation) — costs

may include direct labor, direct materials, costs that may be directly allocable to the

activities involved in fulfilling the contract, costs that are explicitly chargeable to the



customer under the contract and other costs that were incurred only because the entity

entered into the contract (e.g., costs related to the use of subcontractors).

► The costs generate or enhance resources of the entity to be used in satisfying

performance obligations in the future — costs, such as intangible design or engineering

costs, that relate to future performance and will continue to provide benefit

► The costs are expected to be recovered

The proposed model requires that if the costs incurred in fulfilling a contract do not give rise

to an asset under the criteria above, the costs should be expensed as incurred. Costs that

should be expensed as incurred include:

► Costs of obtaining a contract — selling (including commissions), marketing and advertising

costs and costs incurred during the bidding and proposal or negotiations

► Costs that relate to previously satisfied performance obligations — costs incurred directly

related to past performance for which there is no future benefit

► Costs of abnormal amounts of wasted materials, excess labor or other materials used to

fulfill the contract — costs incurred that do not further the satisfaction of the unfulfilled

performance obligation should be expensed as incurred

To the extent the entity is unable to determine whether certain costs relate to past or future

performance, and they are not eligible for capitalization under other US GAAP, those costs

would be expensed as incurred.

How we see it

Current US GAAP provides little guidance on the capitalization of contract costs, including

costs incurred in obtaining a contract. The guidance that does exist is narrow in scope but

is widely used by analogy. For example, many entities currently capitalize items such as

sales commissions by analogizing to the guidance on deferred loan origination costs in

ASC 310, while under the proposed model such costs are required to be expensed as

incurred as they represent a cost of obtaining a contract. The guidance on capitalization of

costs within the proposed model will affect the amounts entities capitalize for the costs

incurred in obtaining a contract and may affect the amounts capitalized for costs incurred

in fulfilling the contract.

For example, under current US GAAP, many entities capitalize the costs of sales

commissions related to service contracts and expense those costs over the related service

period. Those amounts would be expensed under the proposed model. Further, many

telecommunication companies currently limit the amount of capitalized installation costs to

those amounts that are recoverable under the contract, excluding contingent items. Under

the proposed model, these costs could be capitalized to the extent they are recoverable,

without regard to the potential contingent nature of future services and transaction fees.



Any contract costs that the entity capitalizes will ultimately be recognized in income

(generally through amortization) as the entity transfers the related goods or services to the

customer. The proposed guidance requires that assets be amortized to income in a

systematic manner consistent with the pattern of the transfer of goods and services to which

the asset relates. It is important to note that this amortization period could extend beyond a

single contract if the capitalized costs relate to goods or services being transferred under

multiple contracts, or the customer is expected to continue to purchase goods or services

from the entity after the stated contract period.

Any asset recorded by the entity will also be subject to ongoing assessment of impairment

consistent with the proposed guidance on onerous performance obligations. Costs giving rise

to an asset must initially be recoverable in order to meet the criteria for capitalization but

must also continue to be recoverable throughout the arrangement. An impairment exists if

the carrying amount of any asset(s) exceeds the transaction price allocated to the remaining

performance obligations less the costs of satisfying those performance obligations (as

described in Section 7.1).

The proposed guidance does not address whether, once an impairment loss has been

recognized on a capitalized asset, that impairment loss can be reversed if the conditions

causing the impairment loss no longer exist. While the reversal of an asset impairment is

generally not allowed under current US GAAP, such reversal is permitted under IFRS.

Since the ED is intended to be a converged standard, it is not clear which framework this

proposed guidance will follow or, potentially, whether reversals of impairments will be an

area of divergence.

How we see it

The proposed guidance will likely represent a change in practice for the recognition of

costs of sales in many transactions that are comprised of multiple units. In particular, when

the cost of producing individual units varies based on changes in the cost of raw materials,

learning curves experienced with initial products or other variable input costs, the

proposed guidance precludes the normalizing of margins by amortizing costs to units

delivered in equal amounts. Instead, if costs are greater in the early phases of an

arrangement, the costs should be recognized accordingly, resulting in lower profit margins

during the early phases of the arrangement.

7.3 Sale of nonfinancial assets

The ED provides that the proposed guidance would also be applicable to the sale of certain

nonfinancial assets that are not an output of the entity‘s ordinary activities (i.e., not

revenue). This would include the sale of intangible assets and the sale of property, plant and

equipment (including real estate). As a result, the proposed model would provide guidance on

the measurement and recognition of any gain associated with the sale of such assets.



While the ED indicates this guidance will be applicable to those transactions, it does not

provide the proposed language for the new guidance (the ED indicates the current guidance

will be completely superseded). Rather, the ED indicates that the applicable guidance will be

issued at some point during the comment period. However, based on the FASB staff

discussion papers on this issue, we believe that the proposed model will require the entity to

derecognize the asset when the buyer obtains control of the asset and recognize the gain or

loss from the transaction based on the difference between the transaction price and the

carrying amount of the asset. Consistent with the discussion above, the determination of

transaction price would take into consideration a number of factors, and would be limited to

the amounts that can be reasonably estimated.

How we see it

The guidance in the proposed model differs significantly from the stringent requirements that

currently exist for sales of real estate. ASC 360-20 includes specific criteria that must be met

to recognize a sale of real estate as well as a number of additional requirements that must be

met in order to recognize profit on a sale of real estate. For example, under ASC 360-20,

profit recognition on the sale of real estate is not appropriate if the seller finances the

transaction and the buyer‘s initial investment (i.e., down payment) ―does not demonstrate a

commitment to pay for the property.‖ ASC 360-20 provides guidelines for minimum down

payments as well as specific bright line down payment requirements for various types of

property. Under the proposed model, a gain may be recognized for a transaction that does

not meet the requirements of ASC 360-20, provided that the expected transaction

consideration is reasonably estimable and exceeds the carrying amount of the real estate

sold. This will represent a significant change in the accounting for sales of real estate.

Chapter 8: Presentation and disclosure


8.1 Presentation — Contract assets and contract liabilities

The proposed model is based on the notion that when a party to a contract performs, a

contract asset or contract liability is generated. For example, when an entity performs under

a contract by satisfying a performance obligation (i.e., by delivering the promised good or

service), the entity has earned a right to consideration from the customer and, therefore, has

a contract asset. Conversely, when the customer performs first by, for example, prepaying its

promised consideration, the entity has a contract liability.

The proposed guidance requires that the entity present the contract in the statement of

financial position as a contract asset or contract liability when either party to the contract has

performed. In many cases, a contract asset represents an unconditional right to receive the

consideration. This is the case when there are no further performance obligations required to

be satisfied before the entity has the right to collect the customer‘s consideration. The

Boards concluded that an unconditional right to receive the customer‘s consideration

represents a receivable from the customer that is to be classified separately from contract

assets. Contract assets will exist when an entity has satisfied a performance obligation but

does not yet have an unconditional right to consideration, for example, because the entity

first must satisfy another performance obligation in the contract before it is entitled to

invoice the customer.

In addition to the contract asset or liability that is established when either party to the

contract performs, an entity could also have recorded other assets (e.g., costs incurred that

meet the criteria for capitalization) or liabilities (e.g., onerous performance obligations). The

proposed guidance requires that any such assets and liabilities be presented separately from

contract assets and contract liabilities in the statement of financial position (assuming they

are material).

How we see it

The recognition of contract assets and contract liabilities related to a revenue-generating

contract is a new concept for US GAAP entities. Currently, the recognition of similar

assets and liabilities related to contracts (other than contingencies) occurs only in

business combinations.

8.2 Disclosure

8.2.1 Disaggregation of revenue

The disclosure requirements specific to contracts with customers begin with the disclosure of

revenue disaggregated into categories to illustrate how the amount, timing and uncertainty

of revenue and cash flows are affected by economic factors. The proposed guidance suggests

categories such as (a) the type of good or service, (b) the geography in which the goods or

services are sold, (c) the market or type of buyer, such as governmental versus private sector

and (d) the type of contract (e.g., fixed price, time-and-materials).




The following is an example disaggregated revenue table that represents the disclosure

requirement.

Summary of

disaggregated

revenue data

Product A Product B Total

2010 2009 2008 2010 2009 2008 2010 2009 2008

Segment 1 $X $X $X $X $X $X $X $X $X

Segment 2 X X X X X X X X X



Total $X $X $X $X $X $X $X $X $X

How we see it

The notion of providing disaggregated information currently exists within current US

GAAP, for example, ASC 28012 requires public entities to report certain information about

its operating segments. However, the existing guidance generally is limited to public

companies, so the disaggregated reporting requirements will likely be new requirements

for nonpublic companies. Additionally, the proposed model does not provide guidance on

how an entity determines which categories of revenue should be disclosed, unlike the

segment disclosure requirements, which make clear the determination of which operating

segments must be disclosed is based on what information is available to and evaluated

regularly by the chief operating decision-maker. It is unclear how an entity will determine

which categories must be presented to comply with this disclosure requirement.

8.2.2 Reconciliation of contract balances

The proposed model also requires entities to rollforward contract asset and contract liability

balances in the aggregate. The beginning and ending balances of the rollforward must

reconcile to the statement of financial position and include all of the following, at a minimum:

► The amount(s) recognized in the statement of comprehensive income arising from:

► Revenue from performance obligations satisfied during the reporting period

12 ASC 280, Segment Reporting



► Revenue from allocating changes in the transaction price to performance obligations

satisfied in previous reporting periods

► Interest income and expense

► The effect of changes in foreign currency exchange rates

► Cash received

► Amounts transferred to receivables

► Noncash consideration received

► Contracts acquired in business combinations and contracts disposed

The following is an example of the disclosure requirements related to contract balances

assuming the entity has a net contract asset in the aggregate.

Rollforward of aggregate contract assets 20XX 20XX

Beginning balance $ XXX $ XXX

Amounts includes in the Statement of

Comprehensive Income:

Performance obligations (POs) that were

satisfied during the year (revenue) X X

Reallocation of transaction prices to previously-

satisfied POs +/- X +/- X

Interest income (expense) on prepayments and

payments in arrears +/- X +/- X

Effects of changes in foreign currency rates +/- X +/- X

Customer consideration received in advance (X) (X)

Transfers to Accounts Receivable (X) (X)

Noncash consideration received in advance (X) (X)

Acquisitions (disposals) of contract assets +/- X +/- X

Ending balance $ XXX $ XXX



How we see it

While the requirement to provide account rollforwards is new for revenue-related accounts,

these types of disclosures appear to be in line with the Boards‘ ongoing financial statement

presentation project. Based on the information currently available on that project, including

the Staff Draft posted on the FASB‘s and IASB‘s websites in July 2010, the Boards appear

to be moving toward requiring these rollforwards for all significant accounts.

Entities will have to review their current accounting systems to ensure they have the ability

to collect this type of detailed information on account activity. For many companies,

particularly companies with many subsidiaries, multiple reporting currencies, numerous

accounting systems, etc., this may prove to be a difficult data-gathering process.

8.2.3 Performance obligations

The information required to be disclosed for performance obligations under the proposed

guidance is both quantitative and qualitative in nature. First, the entity is required to disclose

the following qualitative items:

► The goods or services the entity has promised to transfer, highlighting any performance

obligations to arrange for another party to transfer goods or services when the entity is

acting as an agent under the contract

► When the entity typically satisfies its performance obligations (e.g., upon shipment, upon

delivery, as services are rendered or upon completion of service)

► The significant payment terms (e.g., whether the consideration amount is variable and

whether the contract has a material financing component)

► Obligations for returns, refunds and other similar obligations

► Types of warranties and related obligations

In addition to the qualitative discussion of performance obligations, the entity is also

required to disclose quantitative information on the expected timing of the satisfaction of

outstanding performance obligations in long-term arrangements. The proposed standard

requires this type of disclosure on any performance obligation with an original expected

duration greater than one year. The disclosure is required to include the amount of

transaction price allocated to performance obligations expected to be satisfied in:

► one year or less

► between one and two years

► between two and three years

► and those expected to be satisfied in more than three years



The following example illustrates this disclosure requirement.

Summary of outstanding performance obligations

with original durations greater than one year

20XX 20XX

Performance obligations expected to be satisfied in

one year or less

$ XXX $ XXX


more than one year but less than two years

XX XX


more than two years but less than three years

XX XX


more than three years

XX XX

Total $ XXX $ XXX

How we see it

The requirement under the proposed model to provide disclosures on the expected timing

of the satisfaction of performance obligations for long-term contracts represents a new

disclosure requirement for entities applying US GAAP. Many entities may not currently

track or collect the data about the expected timing of when performance obligations are

expected to be satisfied that would be necessary to satisfy this disclosure requirement.

8.2.4 Onerous performance obligations

Under the proposed guidance, onerous performance obligations will require additional

disclosures beyond those required for all performance obligations described in Section 8.2.3

above. The following qualitative and quantitative disclosures are required for onerous

performance obligations:

► A description of the nature and amount of the performance obligations for which the

liability has been recognized

► A description of why those performance obligations have become onerous

► An indication of when the entity expects to satisfy the onerous performance obligations

In addition, entities also must disclose a rollforward of any liabilities recorded for onerous

performance obligations. The rollforward must include all of the following components:

► Performance obligations that became onerous during the period

► Performance obligations that ceased to be onerous during the period



► Amount of the liability that was satisfied during the period

► The time value of money

► Changes in the measurement of the liability that occurred during the reporting period

The following example demonstrates the rollforward required under the proposed guidance.

Rollforward of onerous performance obligations 20XX 20XX

Beginning balance $ XXX $ XXX

Performance obligations that became onerous X X

POs that ceased being onerous (X) (X)

Amount of liability satisfied (X) (X)

Time value of money X X

Change in measurement of the liability +/- X +/- X

Ending balance $ XXX $ XXX

8.3 Significant judgments in the application of the new standard

The proposed guidance requires entities to provide disclosures surrounding the significant

judgments made in the application of the proposed revenue recognition model. First, for

transactions in which performance obligations are satisfied continuously (i.e., control is

transferred continuously, which may be the case, for example, for many services and for

certain long-term construction contracts), the entity must disclose both of the following:

► The methods used to recognize revenue (e.g., output methods, input methods, methods

based on the passage of time)

► An explanation of why the method used is a faithful depiction of the transfer of goods or

services

Entities will often exercise significant judgment when estimating the transaction prices of

their contracts, especially when those estimates involve variable consideration or material

amounts of credit. Further, significant judgment may be required when estimating the

standalone selling prices, returns and onerous performance obligations. The proposed

standard requires qualitative information about the methods, inputs and assumptions used

for the following:

► Determining the transaction price in accordance with the proposed model

► Estimating the standalone selling prices of promised goods or services



► Measuring obligations for returns, refunds and other similar obligations

► Measuring the amount of any liability recognized for onerous performance obligations,

including information about the discount rate used in calculating the present value of the

probability-weighted costs expected to be incurred in satisfying the performance

obligation

How we see it

Many of the proposed disclosures pertaining to the significant judgments made in the

application of the proposed model are consistent with the disclosures required in the

recently revised multiple-element arrangements guidance. However, only a limited number

of companies have adopted this revised guidance to date, so for most entities the extent of

these disclosures represent new requirements. While these disclosures likely will not pose

significant issues for an entity with a simple business model, for those entities with multiple

products and business lines, with differing judgments applied to each, the extent of

disclosures required quickly may become cumbersome and more labor intensive.

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