webinar slides: is your company ready for the new revenue recognition standards?

Is Your Company Ready for the New Revenue Recognition Standards?

Presented by: James Comito

June 12, 2014June 25, 2014

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Today’s Presenter

James Comito, CPAShareholder858.795.2029 | [email protected]

A member of MHM’s Professional Standards Group, James has expertise in all aspects of revenue recognition, business combinations, impairment of goodwill and other intangible assets, accounting for stock-based compensation, accounting for equity and debt instruments and other accounting issues. Additionally, he has significant experience with a variety of other regulatory and corporate governance issues pertaining to publicly traded companies, including all aspects of internal control. In addition, James frequently speaks on accounting and auditing matters at various events for MHM.


Today’s Agenda

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Background

Current Practice

Changes Under the New Guidance

4 Next Steps

FASB’S NEW REVENUE RECOGNITION STANDARD

BACKGROUND


The FASB and the IASB initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS that would:

1. Remove inconsistencies and weaknesses in existing revenue recognition standards and practices. U.S. GAAP has multitude of Industry and transaction specific standards. IFRS has two standards on Revenue Recognition IAS 11 and IAS 18.

2. Provide a more robust framework for addressing revenue recognition issues. Weaknesses exist in both set of standards.

3. Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.

4. Simplify the preparation of financial statements by reducing the number of requirements to which entities must refer.

Reasons for the New Guidance


The new guidance utilizes a contract-based approach that places the focus on the assets and liabilities that are created when an entity enters into and performs under a contract.

While some of the concepts in the new guidance are similar to existing guidance, other may change existing practice leading to changes in the amount and timing of revenue recognized.

Reasons for the New Guidance - continued

REVENUE RECOGNITION CURRENT PRACTICE


The current revenue recognition model followed under U.S. Generally Accepted Accounting Principles is focused on the “earning process” (CON-5). Generally, it is appropriate to recognize revenue upon the culmination

of the earnings process. This means the seller must determine when the earnings process is completed (when

the seller has substantially completed what it agreed to do). This determination is not always readily apparent for a variety of reasons.

The determination of “earned” focuses on measurement and recognition thresholds (e.g., the four basic revenue recognition criteria)

Industry guidance also plays a significant role in revenue recognition.

Revenue Recognition Basics


Revenue is generally realized, or realizable, and earned when all of the following criteria are met:

Persuasive evidence of arrangement Price is fixed or determinable Delivery has occurred or service has been rendered Collectability is reasonably assured

Basic Revenue Recognition Criteria

CHANGES TO REVENUE RECOGNITION UNDER THE

NEW GUIDANCE


FASB Accounting Standard Update No. 2014-09

Revenue from Contracts with Customers (Topic 606)

Originally issued: June 24, 2010 Re-exposed during 2011 A second re-exposure completed during 2012 Final standard issued May 2014

Revenue Recognition – The Future has Arrived


Core principle: The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods, or services, to customers in an amount that reflects the consideration to which the entity expects to be entitled, in exchange for those goods or services.

Five steps to apply the core principle:1. Identify the contract(s) with a customer.

2. Identify the performance obligations in the contract.

3. Determine the transaction price.

4. Allocate the transaction price to the performance obligations in the contract.

5. Recognize revenue when (or as) the entity satisfied a performance obligation.

Core Principle and Five-Step Process


Basic Observations On the surface the five step process does not seem overly complex

and arguably, it appears to include much of what is currently done to determine revenue recognition.

However, each of the five steps will require significant judgments by management and auditor in applying the underlying principles included in the new guidance.

The transfer of “control” to the customer becomes the driving issue in evaluating the appropriateness of revenue recognition under the new guidance. Currently, the evaluation of “risk and reward” often drives the

determination of revenue recognition. While it remains an important consideration, it is no longer determinant under the new guidance.

Core Principle and Five-Step Process


1. Identify the Contract with the Customer A contract is an agreement between two or more

parties that creates enforceable rights and obligations.

An entity shall account for a contract with a customer that is within the scope of the guidance only when all of the following criteria are met:

The parties to the contract have approved the contract (written, oral, or in accordance with other customary business practices) and are committed to perform their respective obligations.

The entity can identify each parties rights regarding the goods or services to be transferred.

Five-Step Process


1. Identify the Contract with the Customer A contract is an agreement between two or more

parties that creates enforceable rights and obligations. The entity can identify the payment terms for the goods

or services to be transferred. The contract has commercial substance (that is, the risk,

timing, or amount of the entity’s future cash flows is expected to change as result of the contract)

It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will transferred to the customer.

Five-Step Process


1. Identify the Contract with the Customer A customer is a party that has contracted with an entity to

obtain goods and/or services that are the output of the entity’s ordinary activities.

The revenue recognition guidance is applied to each contract with a customer. Multiple contracts between the customer and the entity are

evaluated for combination.

Five-Step Process


1. Identify the Contract with the Customer Contract Combination

An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer), and account for the contracts as a single contract if one or more of the following criteria are met: The contracts are negotiated as a package with a single

commercial objective. The amount of consideration to be paid in one contract depends

on the price or performance of the other contract. The goods or services promised in the contracts (or some goods

or services promised in each of the contracts) are a single performance obligation.

Five-Step Process


1. Identify the Contract with the Customer Contract Modifications

A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract. there are two paths to consider when evaluating the accounting related to the modification. An entity shall account for a contract modification as a separate

contract if both of the following conditions are present: The scope of the contract increases because it results in the addition of

promised goods or services that are distinct. The price of the contract increases by an amount of consideration that reflects

the entity’s standalone selling prices of the additional promised goods and services and any appropriate adjustment to that price to reflect the circumstances of the particular contract.

Five-Step Process



If a contract modification is not accounted for as a separate contract, an entity shall account for the promised goods or services not yet transferred at the date of contract modification in whichever of the following ways is applicable: An entity shall account for the contract modification as if it were a

termination of the existing contract and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification.

An entity shall account for the contract modification as if it were part of the existing contract if the remaining goods or services are not distinct, and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification.

Five-Step Process



If the remaining goods or services are a combination of the items above, then the entity shall account for the effects of the modification on unsatisfied (including partially unsatisfied) performance obligations in modified contract in a manner that is consistent with the objectives of the relevant paragraph.

Five-Step Process


2. Identifying Performance Obligations A performance obligation is a promise in a contract with a

customer to transfer to the customer: A good or service (or bundle of goods or services) that is distinct. A series of distinct goods or services that are substantially the

same and that have the same pattern of transfer to the customer. Generally explicit but may also include promises that are implied by

an entity’s customary business practices, published policies or specific statements, if at the time of entering into the contract those promises create a valid expectation of the customer that the entity will transfer a good or service to the customer.

Five-Step Process


2. Identify the Separate Performance Obligations A promised good or service is considered distinct if both of

the following conditions are met: The customer can benefit from the good or service either on

its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract)

Five-Step Process


2. Identify the Separate Performance Obligations A customer can benefit from a good or service, if the good

or service could be used, consumed, sold for an amount greater than scrap value, or otherwise held in a way that generates economic benefit. Various factors may provide evidence that the customer can

benefit from the good or service either on its own or in conjunction with other readily available resources. For example, the fact that an entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.

Five-Step Process


2. Identify the Separate Performance Obligations Determining whether the good or service is “distinct within the context

of the contract” is a critical aspect of identifying the performance obligations. Factors that indicate that an entity’s promise to transfer a good or service to a customer is separately identifiable include but are not limited to: The entity does not provide a significant service of integrating the

goods or services into the bundle of goods or services that the customer has contracted for.

The good or service does not significantly modify or customize another good or service promised in the contract.

The good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.

Five-Step Process


2. Identify the Separate Performance Obligations If a promised good or service is not distinct, an entity

shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for

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

Five-Step Process


3. Determining the Transaction Price The transaction price is the amount of consideration that

an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. Issues that impact the determination of the transaction price include the following: Variable consideration Constraining estimates of variable consideration The existence of a significant financing component in the

contract Non cash consideration Consideration payable to a customer.

Five-Step Process


3. Determining the Transaction Price Variable Consideration

Often, part of the contractual consideration related to a good or service is variable in nature or contingent on future events. (not an all inclusive list): Discounts Rebates Refunds Credits Incentives Performance bonuses Royalty

Five-Step Process



An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled: The expected value – the expected value is the sum of probability

weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

The most likely amount – the most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of an amount of variable consideration if the contract has only two possible outcomes.

Five-Step Process



An entity shall include in the transaction price some or all of an amount of variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

Five-Step Process


3. Determining the Transaction Price Factors that could increase the likelihood or the magnitude of a

revenue reversal include, but are not limited to any of the following: The amount of consideration is highly susceptible to factors outside

the entity’s influence. The uncertainty about the amount of consideration is not expected

to be resolved for a long period of time. The entity’s experience (or other evidence) with similar types of

contracts is limited, or that experience (or other evidence) has limited predictive value.

The entity has a practice of either offering a broad range of price concessions or changing payment terms and conditions of similar contracts in similar circumstances.

The contract has a large number and broad range of possible consideration amounts.

Five-Step Process


3. Determining the Transaction Price Reassessment of Variable Consideration

At the end of each reporting period, an entity shall update the estimated transaction price (including updating its assessment of whether an estimated variable consideration is constrained) to represent faithfully the circumstances present at the end of the reporting period and the changes in circumstances during the reporting period.

Five-Step Process


3. Determining the Transaction Price The Existence of a Significant Financing Component in the Contract

In determining the transaction price, a contract must be adjusted for the effects of the “time value of money” when the contract contains a financing component.

A practical expedient is provided that allows an entity to ignore the time value of money when the time between the transfer of the goods/services and payment is less than one year. This is allowable even when the contract itself exceeds one year.

The following factors should be considered when determining whether a significant financing component is present in the contract. The length of time between when the transfer of goods or services to the customer

occurs and when payment is made. Whether the amount of consideration in the contract would substantially differ if the

customer paid cash when the transfer of the goods or services occur. The interest rate in the contract and the prevailing interest rate in the relevant market.

Five-Step Process


4. Allocating the Transaction Price The objective when allocating the transaction price is for an

entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.

To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation in the contract on a relative stand-alone selling price basis. Relative selling price is best evidenced by the observable price of a

good or service when sold separately in similar circumstances and to similar customers.

If a stand-alone selling price is not directly observable, an entity shall estimate the standalone selling price.

Five-Step Process


4. Allocate the Transaction Price When estimating the relative stand-alone selling price,

management should maximize the use of observable inputs. The following are some possible estimation methods (not all inclusive): Adjusted market assessment approach Expected cost plus a margin approach Residual approach (in certain circumstances).

Five-Step Process


5. Recognize Revenue When a Performance Obligation is Satisfied. An entity shall recognize revenue when (or as) the entity

satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Control of an asset refers to the customer’s ability to direct the use of

and obtain substantially all of the remaining benefits from the asset. Indicators that a customer has obtained control are as follows: The entity has a right to payment for the asset. The entity transferred legal title to the asset. The entity transferred physical possession of the asset. The customer has the significant risk and reward of ownership. The customer has accepted the asset.

Five-Step Process


5. Recognize Revenue When a Performance Obligation is Satisfied. Performance Obligations Satisfied Over Time

An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if one of the following criteria are met: The customer simultaneously receives and consumes the

benefits provided by the entity’s performance as the entity performs.

The entity’s performance creates or enhances an asset (WIP) that the customer controls as the asset is created or enhanced.

The entity’s performance does not create an asset with an alternative use to the entity and the entity has a right to payment for performance completed to date.

Five-Step Process


5. Recognize Revenue When a Performance Obligation is Satisfied. Performance Obligations Satisfied at a Point in Time

If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time. The specific point in time is dependent on when the customer obtains control of the promised asset and the entity satisfies the performance obligation.

Five-Step Process


Licenses The new revenue recognition guidance will provide criteria to

distinguish between two types of licenses of intellectual property. A license that provides “access” to IP is considered a

performance obligation satisfied over time. A license that provides a “right to use” an entity’s IP is a

performance obligation that is satisfied at a point in time. The guidance focuses on whether the licensed IP is considered

dynamic or static. A license to dynamic IP is one where the IP might change over time based on actions of the licensor.

A static license grants access to IP that will not change after the license transfers to the licensor.

Other Issues


Disclosures The objective of the disclosure requirements (Topic 606) is

for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The disclosure requirements found in the new revenue recognition

guidance are significantly in excess of what is currently required under U.S. GAAP.

Disclosures


Disclosures An entity shall disclose qualitative and quantitative

information about all of the following: Its contracts with customers The significant judgments, and changes in the judgments made in

applying the guidance in Topic 606 to those contracts Any assets recognized from the costs to obtain or fulfill a contract

with a customer.

Disclosures


Disclosures Contracts with customers Disaggregation of Revenue Contract balances Performance obligations Transaction price allocated to the remaining performance

obligations Significant judgments in the application of the guidance in

Topic 606 Determining the transaction price and the amounts allocated

to performance obligations Practical expedients

Disclosures

PREPARING FOR THE CHANGE NEXT STEPS


Effective Date of Adoption (Public Entity) For a public entity, the amendments in Topic 606 are

effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted.

Next Steps


Effective Date of Adoption (Nonpublic entities) For all other entities (nonpublic entities) the amendments

in Topic 606 are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. A non public entity may elect to apply the guidance in Topic 606

earlier, however, only as of the following: An annual reporting period beginning after December 15, 2016,

including interim periods within that reporting period (public company effective date)

An annual reporting period beginning after December 15, 2016 and interim periods with annual periods beginning after December 15, 2017

An annual reporting period beginning after December 15, 2017, including interim periods within that reporting period.

Next Steps


It is hard to imagine a more significant event to financial reporting than the significant overhaul of historical revenue recognition guidance. History tells us that many entities will misjudge the amount of time, effort and expertise that is required when extensive changes are made to significant accounting guidance. The adoption of fair value and consolidation accounting

guidance is a relatively recent example for us to consider.

Next Steps


The impact from the adoption of the new revenue recognition standard will likely be complex and far-reaching and involve many different functions within an organization. Information systems may require adjustment. Standard “sales” contracts and other sales agreements

should be evaluated in light of the changes. Sales incentives/commissions should be considered. Internal control processes may need updating. Executive compensation arrangements Debt covenants Tax Implications

Next Steps


Changing Business Models? Existing sales strategies and legal documents used in the

selling process may require change or no longer be required under the new guidance.

Over the years many selling strategies have developed to deal with the “bright-line” accounting rules. Upon adoption of the new revenue recognition guidance there is a unique opportunity to rethink the way business is done.

Next Steps


Those entities that are currently subject to significant industry guidance are likely to experience the most significant impact. Telecommunication Software Construction/Aerospace and Defense Real Estate Entertainment and Media Multiple Deliverable Contracts

Next Steps


Transition The FASB has allowed two methods for transition:

Retrospectively to each prior reporting period presented.Practical expedients provided

Retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial adoption. Certain disclosures are required:The amount by which each financial statement line

item is affected in the current reporting period by the application of Topic 606 as compared to the guidance that was in effect before the change.

An explanation of the reasons for significant changes.

Next Steps


Transition and Implementation Challenges for entities with contracts that span multiple

years. What do investors expect? What are your peers likely to do?

Next Steps


Transition and Implementation The implementation of the new revenue recognition

standard should be a team effort across many different corporate functions.

The level of effort and amount of time necessary will be contingent on a number of variables including the size, complexity and previous reliance on industry related revenue recognition guidance.

Start early. With the long “on-ramp” that FASB has allowed for, it is easy for entities to get lulled into a false sense of security. Large public companies with three year P&L presentations face the most time pressure.

Next Steps


Transition and Implementation Consider the use of an implementation team approach.

Existing pricing committees might be a good way to govern the implementation process.

Talk with your auditor and/or professional advisors. Watch for further education opportunities from the FASB

Revenue Recognition Implementation Group.

Next Steps


Q&A

Questions?

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If You Enjoyed This Webinar…

Join us for these related EES courses: 8/14 & 8/26: Revenue Recognition for the Construction

Industry 10/14 & 11/13: Revenue Recognition for the Technology

Industry

Read these related publications: MHM

Messenger 2014-18: Final Revenue Recognition Standard Issued

Additional thought leadership will be published soon now that the new standard has been issued.

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