REVENUE FROM CONTRACTS WITH CUSTOMERS MANUFACTURING INDUSTRY

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1 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE REVENUE FROM CONTRACTS WITH CUSTOMERS MANUFACTURING INDUSTRY OVERVIEW Companies have started gearing p to implement Acconting Standards Codification (ASC) Topic 606, Revene from Contracts with Cstomers. 1 Pblic entities 2 mst apply the new revene recognition rles for annal periods beginning after December 15, 2017, inclding interim periods therein. Therefore, a calendar year-end pblic entity wold reflect the new standard in its first qarterly report for the period ending March 31, 2018, as well as for the entire year ending December 31, Nonpblic entities have an additional year to adopt. The new standard applies for annal periods beginning after December 15, 2018, and for interim periods within annal periods that begin one year later. Therefore, a calendar year-end nonpblic entity wold first apply the new standard for the year ending December 31, If it also prepares interim financial statements, the new standard wold first take effect for those interim periods in All entities are permitted to early-adopt the new standard. 3 ASC 606 establishes comprehensive acconting and disclosre gidance for revene recognition and will replace sbstantially all existing U.S. GAAP on this topic. The new gidelines will be sbstantially converged with IFRS 15, the comparable new standard issed by the International Acconting Standards Board (IASB). MANUFACTURING INDUSTRY CONSIDERATIONS The core principle of the new revene recognition gidance is focsed on the contract between a vendor and a cstomer for the provision of goods and services. Revene is recognized when control over a good or service is transferred to the cstomer, and is based on the consideration to which the vendor is entitled. To accomplish this objective, the standard reqires five basic steps: 1. Identify the contract with the cstomer, 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, and 5. Recognize revene when (or as) the entity satisfies a performance obligation. 1 As promlgated in Acconting Standards Update (ASU) , Revene from Contracts with Cstomers. Over the past three years, the Financial Acconting Standards Board (FASB) has issed varios amendments to ASU based on operational isses raised by the FASB/IASB Joint Transition Resorce Grop and other practitioners. This pblication reflects FASB amendments issed throgh December 31, A pblic entity is one that meets the definition of a pblic bsiness entity in the ASC Master Glossary, as defined in ASU , Definition of a Pblic Bsiness Entity. Under ASU , notfor-profit entities that have issed (or are condit bond obligors for) certain secrities will apply the same effective date as pblic bsiness entities. Employee benefit plans that file or frnish financial statements with the SEC are also considered pblic. Many other entities are considered nonpblic nder the new revene recognition standard. Please see sec/sec-flash-report-jly-2017-(2) 3 Early adoption is permitted for annal reporting periods beginning after December 15, Pblic companies that elect early adoption mst also apply the new standard to interim periods within the annal period of adoption. Nonpblic companies electing early adoption may apply the new standard to interim periods within the annal period of adoption, or to interim periods beginning one year later.

2 2 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE Many entities adopting the new standard will experience changes in the timing and manner of revene recognition. For some transactions, the changes cold be significant and will reqire carefl planning. The following examples demonstrate how the new gidelines may affect companies in the manfactring indstry. We encorage yo to read these examples in connection with ASC 606 itself, and or pblication BDO Knows FASB: Topic 606 Revene from Contracts with Cstomers, which describes the reqirements of the new standard in more detail. The examples and interpretations contained within this pblication cold contine to evolve. As we contine to stdy the new standard and monitor implementation efforts, we may pdate or gidance within this pblication. Revene Recognition Over Time or at Point in Time Under existing U.S. GAAP, companies that prodce certain cstomized prodcts bilt to the cstomer s specifications apply contract acconting in ASC , Constrction-Type and Prodction-Type Contracts. Sch companies are likely recognizing revene sing a percentage of completion method based on either: Inpt measres, sch as the cost-to-cost method, or Otpt measres, inclding the nits of prodction method. Other companies may prodce goods that do not fall within the scope of ASC Revenes from these types of arrangements generally were recognized at a point in time, once sbstantially all of the risks and rewards ownership transferred to the cstomer. Under ASC 606, all contract manfactrers will need to evalate whether the performance obligations shold be recognized over time, or at a point in time. This evalation is reqired regardless of whether the manfactrer had been previosly applying contract acconting nder ASC It is possible that some contract manfactrers that crrently recognize revene sing a cost-tocost method nder legacy U.S. GAAP i.e., recognizing revene over time will change to recognizing revene at a point in time nder ASC 606. Conversely, some manfactrers that crrently record revene at a point in time nder legacy acconting rles may be reqired to recognize revene over time nder ASC 606. Point-in-time revene recognition means that the manfactrer wold recognize revenes once control over the finished prodcts has transferred to the cstomer. Over-time revene recognition means that the manfactrer wold record revenes dring and throghot the manfactring process, even prior to delivering the completed prodcts to the cstomer. ASC 606 reqires over-time revene recognition in any of the following three sitations: 1. The cstomer simltaneosly receives and consmes the benefits provided by the manfactrer as it performs. 2. The manfactrer s performance creates or enhances an asset (for example, work in process) that the cstomer controls as the asset is created or enhanced. 3. The manfactrer s performance does not create an asset with an alternative se to the manfactrer, and the manfactrer has an enforceable right to payment for performance completed to date. For most manfactrers, only the second and third criteria above will be potentially applicable. For the second criterion, this reqirement was inclded to address sitations in which is it clear the cstomer controls the asset. One example is the integration of one cstomer-owned prodct into an additional component prodced by the manfactrer, while another might be a contractal reqirement for the cstomer to own and pay for all work in process. In determining whether the second criterion is met, manfactrers shold consider the indicators of control in paragraph It may be generally clear that the prodct is controlled by the cstomer, bt if it is nclear, the third criterion is applied.

3 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE 3 This third item contains two components, which are described frther in the following table: 4 Manfactrer s performance does not create an asset with an alternative se to the manfactrer A manfactrer cold create an asset that has no alternative se in one of two ways: The cstomer contract or laws/reglations prevent the manfactrer from selling the asset to another cstomer. There are no contractal or legal restrictions preventing the manfactrer from selling the asset to another cstomer, bt the manfactrer is pragmatically limited in its ability to sell the asset to a different cstomer. This cold be becase the asset is highly niqe or cstomized, and the manfactrer either wold incr significant costs to rework the asset or wold only be able to sell it at a significant loss. Manfactrer has an enforceable right to payment for performance completed to date A manfactrer has a right to payment for performance completed to date if the manfactrer wold be entitled to an amont that at least compensates it for its performance completed to date if the cstomer terminates the contract for reasons other than the manfactrer s failre to perform as promised. An amont that wold compensate for performance completed to date incldes both recovery of the costs incrred by the manfactrer in satisfying the performance obligation throgh the cancellation date, pls a reasonable profit margin on those costs. 4 To demonstrate, assme that Red, Inc. manfactres a branded prodct for a cstomer. Under legacy GAAP, revene is recognized on delivery to the cstomer (i.e., the cstomer contract is not within the scope of ASC ). Red determines that each nit ordered is a separate performance obligation or acconting nit. Each manfactred prodct is packaged in boxes prominently displaying the cstomer s logo and, contractally, the prodct can only be sold to the specified cstomer. The cstomer contract contains an enforceable right to payment for performance completed to date. Sch payment wold not only cover Red s costs incrred at any point in time throghot prodction of the branded prodct, bt wold also allow the manfactrer to generate a reasonable profit margin. Frther, the contract contains a provision whereby the cstomer wold take immediate ownership of work in process in the event the contract is cancelled. Under the new revene gidance (bt nlike legacy GAAP), Red wold recognize revenes for each manfactred nit over time (i.e., as each nit is being constrcted). This arrangement meets both the second and third criteria reqiring over-time revene recognition. That is, the cstomer effectively controls work in process becase it can take possession in the event of cancellation (criterion 2), and the contractal restriction precldes Red from selling a nit to another cstomer while Red has an enforceable right to payment throghot the term of the contract (criterion 3). Red determines that work in process is a material amont at the end of each reporting period. Accordingly, Red wold recognize some revene for in-process and completed nits which have not yet been delivered to the cstomer as of the period s end. Red will have to select an appropriate method of measring progress toward satisfying the performance obligation. Appropriate methods of measring progress inclde: Otpt methods (e.g., nits delivered or prodced) Inpt methods (e.g., actal costs incrred relative to total estimated costs to satisfy the performance obligation). Selecting the measre of progress is not a free choice. ASC 606 reqires that the measre of progress be based on the natre of the goods and services that are being transferred to the cstomer. From or earlier example, Red wold likely se a cost-to-cost method or another appropriate inpt measre to recognize revene for each nit pon adoption of ASC 606. Today, some contract manfactrers applying ASC may recognize revene sing the nits-of-delivery method or based on the achievement of certain milestones. Under ASC 606, these methods may no longer be appropriate particlarly when control over a prodct is effectively transferring to the cstomer throghot the manfactring process. 4 In some circmstances, a manfactrer may price a contract at a loss, sally in anticipation of additional ftre orders. The fact that the contract is priced at a loss does not preclde the manfactrer from conclding that the revene shold be recognized over time, as long as the terms of the contract provide for a pro-rata payment for work performed to date pon termination, assming the prodct has no alternative se. Note, the gidance on accral of costs related to loss contracts was not sperceded by ASC 606, and contines to be applicable.

4 4 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE BDO OBSERVATION: It is possible that a manfactrer that is crrently recognizing revene sing a percentage of completion method nder ASC may shift to a point-in-time revene recognition methodology nder ASC 606. For example, assme that an aircraft engine manfactrer crrently recognizes revene sing a cost-to-cost method nder ASC This is becase the engines represent complex aerospace or electronic eqipment bilt to a cstomer s specification. 5 However, the engines cold theoretically be sold to another cstomer for instance, as spares directly to airlines. Therefore, management s performance nder a contract to prodce engines for a cstomer does not in fact create an asset with an alternative se to the manfactrer. Ths, the manfactrer may not meet the criteria in ASC 606 to recognize revene over time if the cstomer does not otherwise obtain control of the prodct as it is being manfactred. Elimination of the Sell-throgh Method Under existing U.S. GAAP, manfactring companies that sell to distribtors might be reqired to se the so-called sell-throgh method to recognize revene. Under the sell-throgh method, a manfactrer does not recognize revene when prodcts are delivered to distribtors. Instead, the manfactrer waits to record revene ntil the distribtors resell the prodcts to the end-sers. The sell-throgh method is sometimes reqired when a manfactrer provides its cstomers (i.e., the distribtors) with general rights of retrn, price protection, or other rights. These rights cold reslt in the selling price not being fixed or determinable, which is a reqired condition to recognize revene nder the existing U.S. GAAP gidelines in SAB Topic 13 (ASC S99). The new revene recognition rles do not reqire the price to be fixed and determinable to recognize revene. The potential price concessions are considered variable consideration sbject to the constraint. Therefore, manfactrers presently sing the sell-throgh method becase there is a significant risk of providing price concessions to distribtors might be able to recognize revene earlier nder ASC 606, if the only ncertainty is the variability in the pricing and control of the prodcts has transferred to the distribtors. The standard provides five indicators that a cstomer (e.g., the distribtor, in this case) has obtained control of an asset, inclding a) the entity has a present right to payment, b) the cstomer has legal title, c) the cstomer has physical possession, d) the cstomer has significant risks and rewards of ownership and e) the cstomer has accepted the asset. When measring the amont of revene to recognize, the manfactrer mst determine the transaction price that is, the amont that it believes it is entitled to receive in exchange for transferring goods and services to its cstomer (i.e., the distribtor). In determining the transaction price, a manfactrer mst estimate variable consideration and review factors that cold case the transaction price to vary pwards or downwards. The estimate may be based on a most likely amont or an expected vale, considering probability-weighted assmptions. The transaction price will then be limited to an estimate of variable consideration for which it is probable 6 that a significant reversal in the amont of cmlative revene recognized will not occr when the ncertainty is sbseqently resolved. In this way, the amont of variable consideration inclded in the transaction price is constrained to an amont that is not likely to be reversed in the ftre. To demonstrate, assme that XDrive, Inc. sells 2,000 disk drives to a distribtor for $50 per nit, bt XDrive provides the distribtor with generos retrn rights and will refnd any price differential if XDrive sells the same prodct to another cstomer at a lower amont. Becase of the nmber of possible otcomes that XDrive has experienced in historical transactions, XDrive has estimated the variable consideration sing an expected vale method, as shown in the table below. 5 See ASC (c), which indicates this type of contract is within the scope of ASC The ASC Master Glossary defines probable as the ftre event or events are likely to occr.

5 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE 5 Consideration for all 2,000 Disk Drives Individal Estimated Probability of Occrrence Cmlative Probability of Occrrence Extended Vale $ 100,000 20% 20% $ 20,000 $ 99,000 10% 30% $ 9,900 $ 98,000 10% 40% $ 9,800 $ 97,000 5% 45% $ 4,850 $ 96,000 5% 50% $ 4,800 $ 95,000 7% 57% $ 6,650 $ 90,000 7% 64% $ 6,300 $ 85,000 5% 69% $ 4,250 $ 75,000 12% 81% $ 9,000 $ 70,000 15% 96% $ 10,500 $ 4% 100% $ $ 86,050 The table indicates that the weighted-average expected transaction price wold be $86,050, bt XDrive wold likely constrain the amont of revene recognized to $75,000. Using a transaction price of $85,000 reslts in a 31% chance (100% 69% cmlative probability) that the ltimate transaction price will be less than this amont, and the amont of potential revene reversal cold be significant (anywhere from $10,000 p to $85,000). Using a transaction price of $75,000 redces the risk of a significant revene reversal in ftre periods when the ncertainties arond any price protection payments or retrns are sbseqently resolved. At this transaction price, it is probable that a significant reversal of revenes will not occr as the likelihood of a $5,000 revene reversal is 19%, and the probability of a $75,000 revene reversal is jst 4%. In many cases, the nmber of possible otcomes will be fewer than shown in this illstrative example. Frthermore, it may not be necessary to qantify probabilities for all possible scenarios if a reasonable estimate of the distribtion of possible otcomes can be determined with a smaller nmber of scenarios. Efficiencies and Learning Crve Costs Similar to existing gidelines in ASC , the new revene rles reqire manfactrers to identify the nits of accont in a cstomer contract. Separate acconting nits are known as distinct performance obligations(s) nder ASC 606. A good or service within a cstomer contract is a distinct performance obligation and a separate acconting nit if: The cstomer can benefit from the good or service either on its own or together with other resorces that are readily available to the cstomer (i.e., the good or service is capable of being distinct) The manfactrer s promise to transfer the good or service to the cstomer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). In applying ASC 606, manfactrers will assess whether orders reqesting mltiple prodcts (or services) shold be considered a single performance obligation, or whether each item within the order wold be considered its own acconting nit. For example, assme that HighQal, Inc. receives an order for 100 heat shrods. HighQal will charge $50 per shrod, which is consistent with the pricing offered to other cstomers. Each shrod takes abot two days to manfactre. Usally, there are normal learning crve costs when the first 8-12 shrods are prodced. Eventally, as prodction ramps p, the per-nit manfactring cost declines. Assme that as of year-end, 10 shrods have been manfactred and control of these prodcts has transferred to the cstomer. Depending on HighQal s determination of the nmber of distinct performance obligations in the cstomer contract, different revene and cost recognition patterns will reslt:

6 6 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE If HighQal concldes that each shrod is a separate nit of accont and that revene shold be recognized at a point in time, the company wold record revene for the 10 delivered shrods as of year-end ($50 x 10 shrods or $500). Moreover, HighQal wold recognize as cost of goods sold the actal costs associated with prodcing those 10 shrods. On a pernit basis, sch costs wold be higher than the anticipated costs of prodcing the remaining 90 shrods in the order. Accordingly, HighQal will record lower margins on the first 10 shrods prodced and transferred to the cstomer, and wold likely show higher margins when the remaining order is flfilled. BDO OBSERVATION: In some cases, it is possible that a manfactrer might recognize a loss on the first few items delivered, bt larger profits on the final items transferred nder the contract. Conversely, in some sitations it might be more appropriate to determine that the entire order represents a single performance obligation. For instance, this cold occr if the cstomer reqests a new design for the shrods, sch that the development of the manfactring process and the prodction of the shrods are interdependent. HighQal wold then need to evalate whether the single performance obligation shold be recognized at a point in time, or over time (as described earlier in this pblication). If revene from the single performance obligation is recognized at a point in time, then any prodction cost wold be recorded in inventory, and charged to cost of goods sold in the period in which control over all 100 shrods is transferred to the cstomer and revenes are recognized. However, if revene shold be recognized over time, then HighQal mst select a sitable measre of the progress toward completion, and recognize revene based on that measre. To demonstrate, assme that HighQal believes the entire 100-nit order will cost $2,000 to prodce, and the first 10 nits actally cost $400 to manfactre. Assming that a cost-to-cost approach is an appropriate measre of progress, HighQal wold recognize $1,000 of revenes [($50 x 100 shrods) x ($400 / $2,000)] at year-end. Provided there are no changes in estimated or actal costs to flfill the order, HighQal wold recognize a consistent profit margin percentage over the entire contract period. BDO OBSERVATION: Under ASC 606, significant inefficiencies that were not reflected in the price of the contract (sch as the costs of nexpected amonts of wasted materials, labor, or other resorces that were incrred to satisfy the performance obligation) shold be expensed as incrred and exclded from a cost-based measre of progress. Optional Prchases and Volme Disconts Sometimes, manfactring and spply contracts inclde cstomer incentives to entice ftre optional prchases. For example, assme that Tinto, Inc., a manfactrer of snglasses, enters into a contract with a new cstomer to sell 10,000 snglasses at $15 each. Moreover, Tinto provides the cstomer with the option to prchase p to 100,000 additional snglasses for $10 each. The offer expires in two months time. Upon entering into a cstomer contract, Tinto shold assess whether any cstomer incentives provide a material right to the cstomer that it wold not have received withot entering into that contract. A material right represents an option to prchase ftre goods and services at a discont that is incremental to the range of disconts typically given for those goods or services to that class of cstomer in that geographical area or market. If the contract provides a material right to the cstomer, the cstomer in effect pays in advance for ftre goods or services. Under ASC 606, this means that a material right is a separate performance obligation at inception of the contract. Part of the transaction price is allocated to the material right and this revene is recognized when those ftre goods or services are transferred or when the option expires. Retrning to the earlier example, assme Tinto normally offers a 20% discont for large prchases i.e., it wold typically price a 100,000-nit blk order at $12 per nit. Since Tinto has agreed to provide a $10 per nit price, the cstomer has received a significant discont that it wold not have obtained withot entering into the initial contract. At inception of the arrangement, Tinto wold establish separate performance obligations for the crrent order and the material right. Typically, Tinto wold allocate the transaction price sing a relative standalone selling price methodology, which wold involve making an estimate of the price at which Tinto wold sell the material right on a standalone basis. However, in this fact pattern, Tinto may employ the practical expedient in ASC This practical alternative is available when the optional goods or services are both (1) similar to the original goods and

7 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE 7 services in the contract and (2) provided in accordance with the terms of the original contract. Under the practical expedient, Tinto determines the total transaction price it expects to receive to be $1,150,000 (i.e., 10,000 nits at $15 per nit and 100,000 at $10 per nit). The amont allocated to the goods or services that Tinto is reqired to transfer is $104,545 (i.e., $1,150,000 divided by 110,000 nits x 10,000 nits) and $45,455 is allocated to the material right ($150,000 transaction price, less the revene allocated to the goods and services reqired to be transferred of $104,545). If the option is exercised, the amont allocated to the material right wold be combined with the $1,000,000 transaction price from the contract renewal and recognized as revene when control of the nderlying nits is transferred. Alternatively, if the option is not exercised, the revene allocated to the material right wold be recognized when the option expires. Had Tinto estimated that the cstomer wold have only ordered 75,000 additional snglasses at the disconted price of $10, then the total price wold be $900,000 (i.e., 10,000 nits at $15 per nit and 75,000 at $10 per nit). Approximately $105,882 of revene wold have been allocated to the original 10,000 snglasses (i.e., $900,000 divided by 85,000 nits x 10,000 nits) and $44,118 of revene wold have been allocated to the material right ($150,000 transaction price, less the revene allocated to the goods and services reqired to be transferred of $105,882). BDO OBSERVATION: If the price offered to the cstomer for the optional goods represented their standalone selling price ($12 per nit based on the volme), the option wold not be a material right, even if it cold only be exercised by entering into the previos contract. Instead, the option wold be ignored ntil and nless it was exercised. Upon exercise, the option wold be acconted for as a contract modification. Contract modifications are described in more depth later in this pblication. Volme rebates, in which a cstomer is offered a rebate if a certain amont of cmlative prchases are made, are not considered a material right. Instead, the rebate is a form of variable consideration which a manfactrer wold consider in estimating the transaction price. For instance, assme that Tinto offers a promotion if a cstomer prchases 100,000 nits over a two-month period, the cstomer will receive a $1-per-nit rebate. At the time each nit is shipped, Tinto invoices the cstomer $15 per nit. Nonetheless, Tinto may conclde that it shold recognize revene at $14 per nit after considering the likelihood that the cstomer will meet the performance target, as well as considering the notion of the constraint. Price Deflation Under the new revene recognition rles, the transaction price is allocated to each performance obligation on a relative standalone selling price basis. If, in a manfactring arrangement, the nit price varies over the dration of the contract, the manfactrer will need to consider whether the change in price is sbstantive and linked to changes in the entity s cost to flfill the obligation or vale provided to the cstomer. To demonstrate, manfactrers may sometimes agree to plan price deflation in contracts with cstomers. For instance, assme CM Co. agrees to sell an electronic component to a cstomer for $100 per nit; however, the price per nit will decline by 2% each qarter over the remaining 18-month term of the contract. The price decreases are designed to correspond with savings that CM will achieve from efficiencies and prodctivity gains as they garner more experience in manfactring the components. Presming that each component is a distinct performance obligation, CM Co. shold not try to levelize the transaction price when allocating it across all of the components to be delivered nder the contract that is, CM shold not se a straight-line methodology to ensre that every nit sold nder the contract is recognized at the same exact transaction price. Instead, CM shold recognize revene based on standalone selling price adjsted for planned price deflation. This is becase the changes in price are sbstantive and linked to changes in CM s cost to flfill the obligation or vale provided to the cstomer. Note that this same conclsion wold reslt if the pricing reset mechanism was based on market terms (e.g., the contract price is benchmarked to a market price or relevant index). BDO OBSERVATION: As described in the prior example, attribting a declining price to nits to be delivered in a cstomer contract may be consistent with the standalone selling price allocation principle in ASC 606 so long as the reasons for the planned price decreases are sbstantive (e.g., to pass along anticipated cost savings and manfactring efficiencies to the cstomer). In contrast, if the reasons for the planned price deflation are not sbstantive, it is not appropriate to allocate declining prices to ftre nits in a cstomer contract. For example, a manfactrer shold not allocate higher prices to the first nits delivered when the cstomer contract incldes planned price redctions simply in an attempt to recognize more revene sooner.

8 8 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE Warranties ASC 606 differentiates between assrance warranties and service warranties: Warranties that only provide a cstomer with the assrance that the prodct will fnction in accordance with agreed-pon specifications are acconted for in accordance with existing gidance on prodct warranties. 7 In contrast, some warranties actally provide the cstomer with a service. For instance, a cstomer cold prchase an extended warranty that reqires the original eqipment manfactrer to repair the good if it stops working after the standard warranty period expires. If a cstomer has the option to prchase a warranty separately, it represents a service warranty that shold be acconted for as a separate performance obligation. Even if a warranty is not sold separately, a manfactrer shold evalate whether it contains a service component in addition to an assrance component. In assessing whether a contract contains a service warranty (in addition to assrance that the prodct complies with agreed-pon specifications), manfactrers shold consider factors sch as the length of the warranty coverage period and the natre of the tasks that the vendor promises to perform. To demonstrate, assme that Valises, Inc. manfactres high-end, designer compter carrying cases. Each compter case comes with a lifetime warranty on parts and labor. The warranty covers any type of damage to the case, no matter the case. Each cstomer contract likely has both an assrance and service warranty de to the length of time covered by the warranty and the fact that it covers damage beyond manfactring defects. Valises wold have to devise an acconting policy, controls, and processes to: Identify the implicit assrance warranty period, as well as the likely period of time cstomers will benefit from the service warranty, Determine what portion of the transaction price is allocable to the service warranty, and 8 Recognize the amont of revene allocated to the service warranty over the anticipated period that cstomers will benefit from the implied service warranty. Revene recognition on the service warranty shold commence starting with the end of the assrance warranty period. BDO OBSERVATION: Under existing GAAP, a separately priced extended warranty is acconted for as a separate acconting nit for which revene is recognized over the extended warranty period, similar to the approach nder ASC 606. However, nder ASC 606, the amont of transaction price allocated to a separately priced extended warranty contract is determined sing a standalone selling price methodology, rather than simply sing its stated contractal price as is the case nder crrent U.S. GAAP. Conversely, nder crrent gidance, a warranty that is not separately priced is generally not acconted for separately, while nder ASC 606, it will need to be assessed to determine whether a portion of the warranty represents a service warranty that mst be acconted for separately. To note, companies will still be reqired to accre costs related to the assrance warranty as reqired nder ASC 460. Contract Modifications A contract modification is a change in the scope and/or price of a contract that is approved by the parties to that contract. Existing U.S. GAAP provides limited gidance on acconting for contract modifications. In contrast, the new revene recognition rles contain a robst framework nder which all contract modifications shold be evalated. Under ASC 606, a contract modification is acconted for as a separate contract and does not affect the original contract in any way if both: The scope of the contract changes de to the addition of promised goods or services that are distinct, and The price of the contract increases by an amont of consideration that reflects the vendor s standalone selling price of the additional promised goods or services, and any appropriate adjstments to that price to reflect the circmstances of the particlar contract. If these criteria are not met, the acconting for the modification will depend on whether the remaining goods or services yet to be transferred from the original contract are distinct from any new goods or services arising from the contract modification. If the remaining goods and services are distinct, the contract modification is acconted for as a replacement of the original 7 See, for example, paragraphs 5-7 of ASC Note ASC indicates If an entity promises both an assrance-type warranty and a service-type warranty bt cannot reasonably accont for them separately, the entity shold accont for both of the warranties together as a single performance obligation.

9 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE 9 contract with a new contract. Any revene and cost remaining to be recognized nder the original contract, pls revenes and costs from the contract modification, are combined into a new contract and the combined arrangement is acconted for prospectively. If the remaining goods and services are not distinct, the contract modification is acconted for as part of the original contract. This will likely reslt in an adjstment to revene recognized to date (i.e., a cmlative catch-p adjstment as of the contract modification date). To demonstrate, assme FlyBy, Inc. is a manfactrer of drones. FlyBy entered into a contract with a cstomer to sell 1,000 drones for $250 per nit. FlyBy has determined that each individal nit is a distinct performance obligation. After 500 nits have been delivered and $125,000 of revene has been recognized, the contract is modified to reqire the delivery of an additional 250 nits at price of $270 per nit. This is lower than the crrent standalone selling price of each drone, which is now $300 per nit de to an increase in the price of a key raw material. FlyBy agreed to a disconted price in order to maintain good cstomer relations. FlyBy determines that the contract modification adds additional nits that are distinct, bt the negotiated price of $270 per nit does not reflect the standalone selling price of the additional prodcts. Accordingly, FlyBy acconts for the modification as a termination and replacement of the original contract with a new contract. FlyBy wold se a blended price of $ per drone as the transaction price of the new contract {[($ prodcts not yet transferred nder the original contract) + ($ prodcts to be transferred nder the contract modification)] 750 remaining total prodcts to be transferred to the cstomer}. Note that revenes and costs associated with the 500 nits delivered nder the original contract terms are not adjsted in any way. Alternatively, consider a sitation in which FlyBy is engaged to design a cstom drone for the U.S. military. As part of the contract, FlyBy mst develop a prototype of the drone, prove that it meets the military s specifications, design and bild a manfactring process, and then prodce 1,000 drones. Given the interrelatedness of the varios stages, FlyBy concldes that there is only one performance obligation, for which revene is recognized over time. After beginning work on the project, the military reqests a change to one of the key specifications, which reslts in incremental costs and billings. This change order represents a modification of the contract. Becase the remaining goods and services to be provided nder the contract are not distinct from the previos efforts, the modification is acconted for as part of the original contract. Revenes recognized to date are revised to reflect the new estimates of total revenes and total costs to be incrred nder the revised contract. Tooling and Set-Up Activities Manfactrers often incr significant costs at inception of a contract for tooling, eqipment and engineering start-p activities. Manfactrers will need to consider whether these pre-prodction activities are a promised good or service or if they are flfillment activities. This will reqire jdgment and consideration of the facts and circmstances. If a manfactrer has difficlty in determining whether a pre-prodction activity is a promised good or service in a contract, it shold consider whether control of that good or service is transferred to the cstomer (e.g., the cstomer will own the reslts of these activities even if the contract is terminated). If so, this may indicate that the pre-prodction activity is a promised good or service. Assme that API Prodctions, Inc. (API) manfactres parts for the car indstry and has entered into a contract with a cstomer to spply pistons. Each piston is determined to be a distinct performance obligation. To flfill the contract, API mst prchase an additional diamond-core ctting machine costing $500,000 and tooling costing $200,000. Frthermore, API will incr engineering costs of $100,000 to configre the prodction line. API will receive $1,000,000 from the cstomer at inception of the contract to compensate for the set-p costs, as well as $10 per piston. API retains title to the eqipment, tooling and any intellectal property (e.g., patents) that reslts from the engineering activities. API is also responsible for maintaining and directing the se of the tooling and eqipment.

10 10 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE Based on these facts, API determines that the pre-prodction activities do not reslt in control of goods or services being transferred to the cstomer. Therefore, the pre-prodction activities are not a promised good or service and cannot be a separate performance obligation within the contract. API wold inclde the pfront $1,000,000 payment within the transaction price, initially recording the amont as a contract liability (deferred revene). A portion of the contract liability wold be derecognized and credited to revenes as control over each piston is transferred to the cstomer (presming the contract consists of mltiple performance obligations i.e., each piston is a separate performance obligation). BDO OBSERVATION: If pre-prodction activities do not represent a separate performance obligation and are related to a performance obligation for which revene is recognized over time (instead of a point in time, as is the case in this example), the pre-prodction activities wold not be considered when measring progress toward completion of that performance obligation becase they do not reslt in control of a good or service being passed to the cstomer. In other words, the manfactrer wold not recognize any revene jst by incrring any of the $800,000 of pre-prodction activities. Instead, the costs wold be treated as costs to flfill a contract. See the next section for frther information on costs of contracts. In contrast, if the pre-prodction activities were determined to be a promised good or service, a portion of the transaction price wold be allocated to that good or service, as either a single performance obligation or as part of a combined performance obligation that incldes the pre-prodction activities along with other goods and services. BDO OBSERVATION: Under existing GAAP, there has been diversity in practice in acconting for pre-prodction costs associated with long-term spply contracts. ASC provides gidance on acconting for the costs of designing and developing molds, dies, and other tools that will be sed in prodcing prodcts nder a long-term spply agreement. ASC 606 did not amend or spersede the gidance provided on pre-prodction costs in ASC Manfactrers that conclded that its pre-prodction costs were within the scope of ASC shold contine to follow that gidance. Companies that analogized to ASC in acconting for similar types of costs shold consider whether changes are necessary. Refer to the next section of this pblication for frther details. In addition, nder existing GAAP, manfactrers have presented monies received from cstomers related to preprodction activities as either revene or a reimbrsement of cost. Companies shold evalate whether their acconting policies contine to be appropriate nder ASC 606. We nderstand that if a pblic company believes that it shold switch from an expense reimbrsement presentation to revene following adoption of ASC 606, it shold conslt (either formally or informally) with the SEC. Cost of Contracts with Cstomers Existing GAAP does not contain explicit gidance on the acconting for costs of obtaining and flfilling a cstomer contract. ASC , Other Assets and Deferred Costs Contracts with Cstomers, was issed concrrently with ASC 606 and provides specific gidance on the acconting for both the incremental costs of obtaining and the costs incrred in flfilling a contract. Before applying ASC , manfactrers shold first evalate whether costs are within the scope of existing U.S. GAAP, sch as ASC 330, Inventory, ASC 360, Property, Plant, and Eqipment, or ASC , Internal Use Software. If no other U.S. GAAP applies, manfactrers shold apply ASC , which reqires the following: Incremental costs of obtaining a contract that the entity expects to recover shold be deferred and amortized on a systematic basis consistent with the pattern in which revene related to the contract is being recognized. As a practical expedient, a manfactrer may recognize the incremental costs of obtaining a contract as a period expense if the amortization period wold have been one year or less. ASC

11 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE defines the incremental costs of obtaining a contract as those costs that an entity incrs to obtain a contract with a cstomer that it wold not have incrred if the contract had not been obtained (for example, a sales commission). Costs incrred in flfilling a contract are those that meet the following criteria: The costs relate directly to a performance obligation nder a contract or anticipated contract; The costs generate or enhance resorces of the vendor that will be sed to satisfy performance obligations in ftre; and The costs are expected to be recovered throgh ftre sales. Costs incrred to flfill a contract shold be acconted for similar to incremental costs of obtaining a contract; however, there is no practical expedient to immediately expense costs incrred in flfilling a contract, even if the related contract will conclde in one year or less. To demonstrate, assme that Rays, Inc., a manfactrer of solar panels, enters into a contract to sell 10,000 nits at $500 per nit to a new cstomer. Rays sed an external sales agent to facilitate the sale and owes the agent a sales commission of 0.5% of the contract price, payable pon signing the contract. Rays incrred legal costs of $5,000 for drafting the cstomer contract and $2,000 for checking the cstomer s creditworthiness. Once the contract was signed, Rays prchased tooling for $25,000 and incrred engineering costs of $100,000 to facilitate prodction of the solar panels. The tooling and engineering activities do not represent a good or service which is transferred to the cstomer (Rays retains title and control of the tooling and owns and controls all intellectal property arising from the activities). Rays first determines if any of the costs are within the scope of any existing U.S. GAAP. The tooling wold be eqipment prchased by Rays acconted for in accordance with ASC 360, Property, Plant and Eqipment. Rays determines that the engineering activities are within the scope of ASC 730, Research and Development, and the costs shold be expensed as incrred. This is becase the costs meet the definition of development activities, and are not specific to the cstomer contract. That is, the intellectal property reslting from the engineering efforts can be sed by Rays to flfill other ftre cstomer orders. Rays wold then apply the provisions of ASC The commissions of $25,000 (0.5% x $500 x 10,000) wold not have been incrred except for the fact that Rays obtained the new contract, and Rays expects to recover the costs throgh revene obtained nder the new contract. These costs wold be deferred nder ASC and amortized proportionally in the same pattern that revenes from the contract will be recognized. The legal ($5,000) and credit review ($2,000) costs wold be expensed as incrred, as they are not incremental costs of obtaining a contract. Simply, these costs wold have been incrred even had the contract not been signed. BDO OBSERVATION: In certain instances, commissions paid at inception of a cstomer contract exceed those paid pon contract renewal, if any. In these sitations, carefl consideration shold be given on whether the manfactrer may apply the practical expedient of immediately recording the incremental payments as a period expense. That is, the manfactrer shold evalate whether the amortization period is actally one year or less. Specifically, the amortization period for the initial commissions wold be one year or less if (a) the commissions paid at contract renewal are commensrate with (b) the commissions paid at contract signing. To demonstrate, assme BitPart, Inc. enters into a oneyear, $100,000 renewable maintenance contract with a cstomer. BitPart pays a 5% commission on contract signing to its sales agent, and will pay that same individal a smaller 1% commission pon contract renewal. The difference in the renewal rates stems from BitPart s belief that the level of effort necessary to obtain a renewal is far less than initially entering into a new contract. The FASB staff indicated that the level of effort to obtain a contract or renewal shold not factor into determining whether the commission paid on a contract renewal is commensrate with the initial commission. Instead, a renewal commission is commensrate with an initial commission if the two commissions are reasonably proportionate to the respective contract vales (e.g., both are 2% of the amonts invoiced to cstomers). Therefore, if a contract does not contain commensrate commissions, the initial commission may relate to a contract period beyond the initial term. Retrning to or example, the initial and renewal commissions are not commensrate. Accordingly, BitPart wold not qalify for the practical expedient and instead wold defer and amortize the initial commissions over a period that considers both the initial contract term and any expected renewals. If the cstomer is expected to renew the contract for times, BitPart wold:

12 12 INSIGHTS FROM THE BDO MANUFACTURING PRACTICE Consider the gidance in ASC that reqires deferred costs to be amortized on a systematic basis that is consistent with the transfer to the cstomer of the goods or services to which the asset relates. As revenes from the contract will be recognized in a consistent amont of $100,000 per year, BitPart determines that any deferred costs shold be recognized on a similar straight-line basis. In aggregate, BitPart anticipates paying commissions of $9,000 [$5,000 initial commission + (4 years x $1,000 renewal commissions)]. Accordingly, BitPart wold record $1,800 of commission expense per annm ($9,000 / year anticipated amortization period). Specifically, BitPart wold record the initial $5,000 commission payment as a deferred cost, and wold amortize $1,800 of that deferred cost in the first year of the contract. BitPart wold then amortize $800 of the remaining deferred cost per year in each of the next for years; that amont, added to the $1,000 of commissions paid in each renewal period, wold reslt in a total $1,800 of commission expense each year. It may also be acceptable for BitPart to amortize the $5,000 over the five years of expected contract life, and sbseqently expense each $1,000 renewal commission in the year to which it relates, as long as BitPart applies one approach consistently to all similar contracts. TRANSITION METHODS Both pblic and nonpblic entities may adopt ASC 606 sing a fll retrospective approach whereby all prior periods presented are restated. When sing this transition method, certain practical expedients are permitted, as described below: Contracts that begin and end in the same annal reporting period wold not need to be considered nder ASC 606. Entities can se hindsight in acconting for contracts that contain variable consideration. That is, entities may se the final transaction price at the date the contract was actally completed, rather than estimating the variable consideration at inception and at each comparative reporting period. Entities can elect to reflect the aggregate effect of all modifications that occr before the beginning of the earliest period presented when identifying the satisfied and nsatisfied performance obligations, determining the transaction price, and allocating the transaction price to the satisfied and nsatisfied performance obligations. Entities are not reqired to disclose the amont of a contract s transaction price that was allocated to the remaining performance obligations or an explanation of when those obligations are expected to be recognized as revene for reporting periods presented before the date of initial application (e.g., Janary 1, 2018, for a calendar year-end pblic entity). Alternatively, entities can elect to adopt ASC 606 sing a cmlative effect approach. Under this approach, an entity wold apply the new revene standard only to contracts that are incomplete nder legacy U.S. GAAP at the date of initial application (e.g., Janary 1, 2018, for a calendar year-end pblic company) and recognize the cmlative effect of the new standard as an adjstment to the opening balance of retained earnings. That is, prior years wold not be restated.; however, additional disclosres wold be reqired to enable sers of the financial statements to nderstand the impact of adopting the new standard in the crrent year compared to prior years that are presented nder legacy U.S. GAAP.