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Proposed Revenue Recognition Standards

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This memorandum provides an overview of the new model for revenue recognition exposed in Proposed Accounting Standards Update (ASU) No. 2011-230, Revenue Recognition (Topic 605):  Revenue from Contracts with Customers, Revision of Exposure Draft Issued June 24, 2010.

Stated objectives of proposed guidance

In November 2011, the Financial Accounting Standards Board (FASB) issued the aforementioned proposed ASU.  The proposed guidance, if adopted, would establish a core principle which states that an entity must recognize revenue in a manner that represents the entity's transfer of goods and services to customers, as promised, measured at the amount that reflects the consideration the entity expects to receive from the exchange.

Scope of proposed guidance  

Financial accounting standards provide guidance for certain contracts addressed elsewhere in the Codification.  The ASU, therefore, excludes such contracts from the scope of the new guidelines, as follows:

  • Leases;
  • Insurance contracts;
  • Receivables;
  • Debt and equity securities;
  • Liabilities and debt;
  • Guarantees;
  • Derivatives;
  • Financial instrument
  • Transfer and servicing rights; and
  • Nonmonetary exchanges.

Issuers of publicly-held securities in the United States must follow the accounting rules and interpretations established and approved by the SEC. The regulatory agency has provided detailed guidance on revenue recognition.  If the FASB adopts the proposed ASU, the SEC staff is expected to reconcile its guidance with the new U.S. GAAP guidance.

The five-step process for implementing the guidelines

The proposed ASU directs entities to account for and present revenue in the amount and at the time that reflects the consideration expected to be received in exchange for goods and services. To accomplish this objective, the exposed guidance establishes a five-step process for the recognition of revenue from contracts with customers:

Step 1 – Identification of the contract with the customer

Under the proposed ASU, only contracts that contain certain criteria (including commercial substance, approval by the parties, and a commitment to perform) qualify for consideration of revenue recognition. In the proposed guidance, an arrangement that gives a party the unilateral right to terminate is not a contract for revenue recognition.

If multiple contracts meet certain conditions, an entity may account for the arrangement under the proposed guidelines as a single contract. Such conditions for combining contracts include the following:

  • The parties negotiate multiple contracts as a single package;
  • The receipt of consideration from one contract depends upon the entity's performance of   another contract; and
  • The goods and services in the separate contracts constitute a single performance obligation.

The proposed ASU addresses the consideration of segmenting contracts within the guidance regarding Step 4, allocation of consideration to performance obligations, discussed below. The guidelines in the proposed ASU, for combining and segmenting contracts, may provide different results than under current guidance for long-term contracts.

In addition, the proposed ASU addresses how the guidelines would apply to the identification of a contract subject to modification. Generally, under the proposal, a contract modification is a change in the scope or price of the contract. In such cases, the entity must determine how to account for the modification under the guidelines in the following situations:

      • A price renegotiation;
      • A new and separate contract;
      • A modification of the existing contract that creates a distinct additional performance obligation; or
      • A modification of the existing contract that does not create a distinct additional performance obligation.

Step 2 – Identification of the seller’s performance obligations  

The proposed ASU states that a good or service generally is a distinct performance obligation if either of two criteria are satisfied:

  • The entity regularly sells the product or service separately; or
  • The customer obtains benefit from the good or service, either from the item on its own or in combination with other items readily available, such as sold by another entity.

Goods and services transferred to a customer as part of a bundle, however, are not distinct under the proposed guidance, if the terms satisfy both the following criteria:

  • The transferred goods and services are highly interrelated and require a high degree of integration that is a part of the contract; and
  • The bundle of goods and services has been significantly modified or customized for the customer under contract specifications.

Granting a customer the right to return products sold, in itself, typically does not create a separate performance obligation for the seller. The issue of expected customer returns is addressed as part of Step 3, determining the contract price, discussed below.  Specifically, the proposed guidance requires an assessment of returns as part of the estimation of variable consideration.

Application of the guidelines would require an entity to assess whether a product warranty gives the customer assurance to the conformity of the goods delivered to agreed-upon standards or constitutes a separate performance obligation. In the latter case, the proposed guidelines would require the entity to allocate the contract price. The proposed ASU provides implementation guidance concerning warranties.

The effects of separation of a contract into performance obligations, as would be required by the proposed revenue recognition guidelines, can be illustrated by a consumer wireless communications contract. The provider generally gives the customer equipment for free or at a reduced price when the customer executes a service contract. Under current accounting guidance, the revenue from the contract typically is recognized ratably over the contract. Under the proposed model, however, the contract would likely be segregated into two distinct performance obligations, delivery of the equipment and the access services.

Careful judgment would be required in applying the proposed revenue recognition guidance, particularly with respect to the identification of distinct performance obligations.

Step 3 – Determination of the transaction price

The propose ASU requires that a seller must determine the total consideration to which the entity expects to be entitled from the customer in exchange for the goods and services that the entity has promised to transfer to the customer.

The proposed guidance addresses consideration in a contract that may vary due to discounts, rebates, refunds, bonuses, price concessions, penalties, and similar terms.  When the contract price contains variable components, an entity must estimate the total contract consideration using either of the following:

  • Expected value: The sum of the probability weighted amounts that the entity expects for the exchange; or
  • Most-likely amount: The single amount that the entity expects as the most likely result for the exchange.

In addition, when determining the contract price under the proposed ASU, the seller must consider the effects of certain terms of the arrangement:

  • Implicit financing and time value of money:  A seller must adjust the amount of contract consideration to reflect the time value of money if the contract has a significant financing component. Generally, the seller would not adjust for the time value of money if it expects at the inception of the contract that the transfer of goods and services in exchange for payment will conclude within one year;
  • Non-cash consideration: A seller would consider the fair value of any noncash consideration promised or goods and services contributed by the customer;
  • Consideration given to the customer.

The proposed ASU would not change current guidance with respect to an entity's assessment of a customer's credit risk, nor does it change collectibility, recognition and measurement of bad debts. The new guidance, however, would require entities to report these bad debts on the face of the income statement in a line just below revenues.

A significant change from current practice involves variable consideration. Under current guidance, an entity recognizes revenue from a transaction only to the extent that is not subject to contingencies.  The proposed ASU permits an entity to consider the most likely amount for the exchange.  Accordingly, it provides guidelines concerning variable consideration. Implementation of the proposed ASU will necessitate careful judgment in establishing the sales price of an exchange, particularly if certain consideration is subject to contingencies.

Step 4 – Allocation of the transaction price to separate performance obligations

The entity must allocate the total transaction price (determined in Step 3) to each separate performance obligation in an amount that represents the consideration that the entity expects to receive from the exchange or satisfaction of that performance obligation.

The new guidance, if adopted, would generally require sellers to allocate the total transaction price to each performance obligation on the basis of their relative standalone selling prices at inception. The proposed guidelines further state that the best evidence of a standalone selling price is the observable amount that the seller receives from a similar performance obligation delivered separately. In the absence of an observable standalone price, the seller may estimate the standalone price, it but must do so using observable inputs to the extent that they are available.

In addition, the proposed ASU contains specific guidelines regarding the following:

  • Allocation of discounts to multiple performance obligations; and
  • Allocation of consideration when a portion of the price remains contingent on future events.

The proposed ASU has implementation guidance and examples that illustrate the allocation of the contract price.

Step 5 – Determination of when performance obligation is satisfied and revenue is recognized

The proposed guidelines state that a performance obligation is satisfied when the entity transfers goods or services to the customer. The transfer is deemed to occur when the customer obtains control over the goods or services, demonstrated by the ability to direct the use of the items and receive benefits from them.

The proposed ASU provides that an entity generally fulfills performance obligations in one of the following two ways:

  •  Transfer of control to the customer at a point in time.  The transfer of control may be established by various indicators, including the following:

—    The right to receive payment from the customer;

—    The customer's legal title to the asset;

—    The transfer of legal possession of the asset; and

—    The transfer of the risks and rewards of ownership.

  • Transfer of control to the customer over time.  The transfer of control over time applies if the circumstances satisfy one of the following two criteria:

—    The entity's work creates or enhances an asset already controlled by the customer; or

—    The entity's work does not create an asset with alternative use and either:

  1.           a.  The customer simultaneously receives and uses up the benefits of the entity's work;
  2.           b.  The customer would, if necessary, be able to select another vendor-entity to complete the work without re-performance of the entity's work; or
  3.           c.  The entity expects compensation for portion of the work it has completed.

Under the proposal, many long-term contracts typically would be deemed to transfer control to the client over time. In such cases, the seller must use an accounting method that best represents the earnings process, which may be one of the following:

  • Output methods, such as meeting certain milestones or the percentage of goods or services produced and delivered to the agreed-upon total;
  • Input methods, such as costs or efforts expended; or
  • Time-based methods, such as a straight-line.

In cases of transfer of control to a client over a time period greater than one year, an entity must accrue a loss if the lowest cost of fulfilling a performance obligation exceeds the amount of the transaction price allocated to that performance obligation. Therefore, the guidelines may require an entity to recognize a loss on a particular performance obligation even if the overall contract is profitable.  Accordingly, the profit center for purposes of financial reporting will no longer be the contract; it will be the individual performance obligations that make up the contractual arrangement.

The proposed ASU has implementation guidance and examples regarding the fifth step of revenue recognition, as follows:

  • Repurchase agreements, including obligations specified in forwards and options;
  • Bill-and-hold arrangements;
  • Customer acceptance;
  • Shipment of a product with specified terms regarding risk of loss in transit;
  • Assets with alternative uses; and
  • Measurement of progress toward completion using an input method.

Under current guidance, an entity may recognize revenue when the entity transfers the risks and rewards associated with the goods or services to a customer. The timing of revenue recognition under the new proposal is when control of the goods or services under the contract in question transfers to the client.

Under the proposed ASU, the transfer of the risks and rewards of ownership is just one factor to consider for determining whether a customer has obtained control.  Application of the new criteria may result in a significant change to current practice.

Many representatives of contracting entities have argued that the new guidance would eliminate the current percentage-of-completion method, and as a result, financial reporting for such entities would be less transparent and meaningful. However, FASB representatives and other professionals have responded that contracting entities would continue to use a substantively similar method to the percentage-of-completion based on project progress measured using input, output, or time-based methods.

Effective date and transition measures

The FASB has not yet adopted the propose ASU. The proposal reports the Board's expected timetable for the project and states that a final standard would not be effective earlier than reporting periods that begin on or after January 1, 2015 (i.e., December 31, 2015 year ends and thereafter). The Board further indicated its intention to adopt a new standard using a timeframe that will permit entities to present two years of comparative annual information using the amended guidelines.

The Basis for Conclusions in the proposed ASU, emphasizes the standard-setters' intention to require retrospective application of the new guidelines (i.e., restating previously financial statements presented in the year of adoption) when the guidelines are adopted.  The FASB has also stated that it will not permit early adoption of a final standard when issued.

Upon adoption, both public and nonpublic entities will be required to comply with the new revenue recognition guidelines. The current exposure draft, however, exempts nonpublic entities from certain quantitative and qualitative disclosure requirements.

We would be happy to meet with you to go through this memo. Please call us with any questions you may have.

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