Revenue Changes for Franchisors. Revenue Changes for Franchisors

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1 Revenue Changes for Franchisors

2 Table of Contents INTRODUCTION... 4 PORTFOLIO APPROACH... 5 STEP 1: IDENTIFY THE CONTRACT WITH A CUSTOMER... 6 COMBINING CONTRACTS... 7 STEP 2: IDENTIFY PERFORMANCE OBLIGATIONS IN A CUSTOMER CONTRACT... 7 IMMATERIAL ITEMS... 8 MATERIAL RIGHT Loyalty Programs SERIES PROVISION STEP 3: DETERMINE THE TRANSACTION PRICE VARIABLE PRICING & CONSTRAINT SIGNIFICANT FINANCING COMPONENT NONCASH CONSIDERATION STEP 4: ALLOCATE THE TRANSACTION PRICE TO PERFORMANCE OBLIGATIONS LOYALTY PROGRAMS ALLOCATING DISCOUNTS STEP 5: RECOGNIZE REVENUE PERFORMANCE OBLIGATIONS SATISFIED OVER TIME CONTROL TRANSFERRED AT A POINT IN TIME LICENSING & RIGHTS TO USE INTELLECTUAL PROPERTY Sales-Based or Usage-Based Royalties OTHER ITEMS PRINCIPAL VERSUS AGENT CONSIDERATIONS CUSTOMER'S UNEXERCISED RIGHTS "BREAKAGE" CONTRACT COSTS Incremental Costs of Obtaining a Contract Costs to Fulfill a Contract REVENUE PRESENTATION SALES TAXES DISCLOSURES DISAGGREGATION OF REVENUES CONTRACT BALANCES REMAINING PERFORMANCE OBLIGATIONS ADOPTION

3 CONCLUSION CONTRIBUTOR

4 Introduction Revenue recognition will change with the adoption of Accounting Standards Update (ASU) , Revenue from Contracts with Customers (Topic 606), which supersedes most industry-specific guidance and adds significant disclosures. Implementation is a significant undertaking for entities across all industries. Franchisors face additional challenges due to the variety of revenue streams and extent of changes to current guidance and practice. The effect on each company will vary depending on existing income streams, customer base and current estimation methodologies and accounting elections. This paper focuses on those items in the new model that will have the greatest effect on franchisors. U.S. Securities and Exchange Commission (SEC) filings for public entities 1 after initial adoption indicate the biggest changes will be: Initial franchise fees. Under Accounting Standards Codification (ASC) 606, these will now be recognized over the term of the agreement rather than upfront on opening or when a renewal agreement becomes effective. Incentive management fees. Currently, many companies recognize the amount that would be due if the management contract was canceled at the end of the reporting period. Under ASC 606, incentive management fees would be recognized to the extent that it is probable a significant reversal will not occur, which could be later than current practice. This is likely to primarily affect interim reporting. Contract assets and liabilities. This is a new concept for most industries other than construction. Under ASC 606, reclassification from a contract asset to a receivable is contingent on fulfilling performance obligations not on invoicing a client. As a result, the point at which a contract asset is reclassified as a receivable may be different than the time of invoicing. Advertising fund contributions. Many franchisors recognize these amounts as a reduction to advertising expenses. Under ASC 606, franchisors may be required to recognize the funds on a gross basis, with advertising fund fees included in revenue and the related advertising expense included in operating expenses. Loyalty programs. Many programs currently recognize points or benefits on a gross basis at issuance along with an accrual of the expected future cost. Under ASC 606, benefits are recognized at redemption, net of any reimbursement to a third party. Fees received in excess of the estimated liability for loyalty programs may be considered a contract liability. Contract acquisition costs. Depending on current practice, certain costs related to management and franchise contracts may be recognized over the term of the contracts as a reduction to revenue, instead of as amortization expense. Breakage. For companies that issue gift cards, the timing of when a company can derecognize a contract liability and recognize revenue may change depending on current accounting practice. Presentation of sales taxes. The standard creates a new accounting policy election to present sales taxes collected from customers on a net basis. In general this is current practice for most companies; however, to continue under ASC 606, an entity must make this accounting policy election. Additional disclosures. These are needed around the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. 1 A public entity is defined as any one of these: A public business entity A not-for-profit entity that has issued or is a conduit bond obligor for securities traded, listed or quoted on an exchange or over-the-counter market An employee benefit plan that files or furnishes financial statements to the SEC 4

5 Effective Dates Revenue Recognition (ASC 606) Public Entities 1 Annual and interim reporting periods beginning after December 15, 2017 All Others Annual reporting periods beginning after December 15, 2018, and subsequent interim periods Dunkin Brands Group, Inc. 1Q Q The Company expects the adoption of the new guidance to change the timing of recognition of initial franchise fees, including master license and territory fees for our international business, and renewal fees. Currently, these fees are generally recognized upfront upon either opening of the respective restaurant or when a renewal agreement becomes effective. The new guidance will generally require these fees to be recognized over the term of the related franchise license for the respective restaurant, which we expect will result in a material impact to revenue recognized for initial franchise fees and renewal fees. The Company does not expect this new guidance to materially impact the recognition of royalty income. Additionally, rental income is outside the scope of this new guidance, and therefore will not be impacted. The Company also expects the adoption of this new guidance to change the reporting of advertising fund contributions from franchisees and the related advertising fund expenditures, which are not currently included in the consolidated statements of operations. The Company expects the new guidance to require these advertising fund contributions and expenditures to be reported on a gross basis in the consolidated statements of operations. However, we expect such contributions and expenditures to be largely offsetting and therefore do not expect a significant impact on our reported net income. Even if timing or revenue recognition does not change, disclosure and internal controls and systems will. Extended Stay America, Inc. 1Q Q Adoption of ASC 606 had no impact to the recognition of revenue in the Company s unaudited condensed consolidated financial statements. The Company recognized no cumulative effect adjustment upon adoption. Adoption of the standard resulted in enhanced revenue-related disclosures that provide information with respect to the Company s analysis of certain contracts, significant judgments and the disaggregation for owned hotel room revenues by booking source and length of guest stay. Although ASC 606 is not expected to have a material impact to the Company s ongoing net income, the Company implemented changes to its processes and procedures related to revenue recognition and the control activities within them. These included the development of new policies based on the five-step model, training and ongoing contract review procedures with respect to the validation of information used in financial statement disclosures. Dunkin Brands Group, Inc. 1Q Q Additionally, the Company is in the process of implementing new accounting systems, business processes, and internal controls related to revenue recognition to assist in the application of the new guidance. Portfolio Approach For larger franchisors with a sizable volume of contracts, the Financial Accounting Standards Board (FASB) recognized the challenges of applying ASC 606 on a contract-by-contract basis and provided a practical expedient. Franchisor entities can apply the practical expedient if the portfolio has similar characteristics and the entity reasonably expects that the effects will not differ materially from applying the guidance to individual contracts. Because this is a practical expedient and not a requirement, an entity can choose to apply it to certain types of contracts and use it on an individual contract basis for others. The expedient is available for all aspects of the 5

6 model or only for certain steps. In establishing portfolios, entities will need to use judgment to determine the size, composition and number of portfolios. Each organization is unique, and portfolios will depend on the customer base and accounting system capabilities. Entities should consider the experience with and homogeneity of the portfolio to ensure the data is useful to predict an expected outcome. The standard does not mandate a specific approach in assessing materiality if using the portfolio approach will produce a different outcome than applying the guidance on an individual contract basis. An entity must demonstrate in a reasonable manner, using some form of objective and identifiable information why it expects the two approaches will not differ materially. Extended Stay America, Inc. 1Q Q As a practical expedient, the Company elected to apply its contract review to portfolios of contracts with similar characteristics as the Company expects the effects of applying these contracts on a portfolio basis compared to an individual basis would not have a material impact to the Company s unaudited condensed consolidated statement of operations. The Company applies a portfolio approach in its review of contracts or performance obligations that have similar characteristics. Contract portfolios reviewed include: (i) Rooms sold on-site at the property, through the Company s call center and website (ii) Rooms sold by the Company s sales team (iii) Rooms sold by traditional and online travel agents, including merchant and opaque arrangements Step 1: Identify contract with customer Step 2: Identify performance obligations Step 3: Determine transaction price Step 4: Allocate transaction price Step 5: Recognize revenue Disclosures Step 1: Identify the Contract with a Customer In the hospitality industry, the customer and the contract terms are easily identifiable. The new revenue standard defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. Accounting for contracts with customers under the new model only begins when all the following criteria are met: Commercial substance Collectible Contract Approval and commitment Identifiable rights, obligations and payment terms 6

7 Combining Contracts Contracts entered into at or near the same time with the same customer (or related parties) should be combined if one or more of the following criteria are met: Contracts are negotiated together with a single commercial objective Pricing interdependencies exist between contracts Goods or services in the contracts represent a single performance obligation (see Step 2 Identify Performance Obligations) When the standard was first issued, companies were concerned with how this requirement would affect the hospitality industry. The American Institute of CPAs (AICPA) Hospitality Entities Revenue Recognition Task Force (task force) addressed this issue. The task force concluded that goods and services purchased by the customer on a standalone basis separate from the hotel reservation are distinct promised goods and services that should be accounted for as separate contracts. However, for package hotel reservations, depending on the specific facts and circumstances, the hotel owner may identify multiple performance obligations one for the hotel reservation and one for each type of ancillary service because the hotel regularly sells these items separately. Extended Stay America, Inc. 1Q Q When a reservation is made, the Company deems that the parties have approved the contract in accordance with customary business practices and are committed to perform their respective obligations. At such time, each party s rights regarding the services to be transferred are identified, payment terms for services to be transferred are specified, the contract has commercial substance and, in most instances, it is probable the Company will collect substantially all consideration to which it will be entitled in exchange for services. Step 2: Identify Performance Obligations in a Customer Contract Under ASC 606, performance obligations and fulfillment of them determine revenue recognition. Properly identifying the performance obligations will be time-consuming but critical because these determinations drive the pattern of revenue recognition and financial statement disclosures. A performance obligation is a promise to transfer goods or services to a customer that can be explicitly identified in a contract or implied by customary business practices, published policies or specific statements. This is complicated as franchise arrangements contain multiple elements, e.g., licensing of intellectual property, access to reservation systems and marketing. Both of the following criteria must be met for a promised good or service to be considered distinct and a separate performance obligation: Capable of being distinct because the customer can benefit from the good or service on its own or with other readily available resources Distinct within the contract s context the good or service to the customer is separately identifiable from other promises in the contract. The following indicators would be used to evaluate if a good or service is distinct within the contract s context: Significant integration services are not provided The goods are not highly interdependent or interrelated The good or service does not significantly modify or customize another good or service promised in the contract 7

8 Companies must use judgment in determining which promises represent distinct performance obligations. When a promise is not considered distinct, it is bundled with other promises until the bundle constitutes a distinct performance obligation. Franchisors often will conclude that certain activities, e.g., pre-opening activities or the administration of an advertising fund, do not constitute distinct performance obligations and are bundled together as a symbolic license. This will be a significant judgment and will depend on the unique facts and circumstances for each franchise arrangement. In many cases, it is likely that other than equipment, the activities undertaken by the franchisor either will not represent promised goods or services because they are essentially setup activities or will not be considered distinct promised goods or services because, without the license of the IP, they provide little to no benefit on their own (or together with other readily available resources) or they cannot be separately identifiable from the license of the IP. Immaterial Items FASB did not expect entities to identify significantly more performance obligations than the deliverables identified under current guidance. However, concerns arose since the standard s basis for conclusions noted the current SEC guidance on inconsequential or perfunctory items was intentionally not carried forward into ASC 606. A subsequent amendment in ASU permits entities to disregard promises deemed to be immaterial in the contract s context. In addition, such items would not be required to be aggregated and assessed for materiality at the entity level for auditing purposes. The AICPA task force concluded that the separate components of providing a hotel accommodation, e.g., room, toiletry items, housekeeping and amenities, are not distinct within the context of the contract as they are all highly dependent and interrelated as part of the obligation to provide the lodging facility. Marriott International, Inc. 1Q Q For our managed hotels, we have performance obligations to provide hotel management services and a license to our hotel system intellectual property for the use of our brand names. For our franchised hotels, we have a performance obligation to provide franchisees and operators a license to our hotel system intellectual property for use of certain of our brand names. We provide hotel design and construction review quality assurance ( Global Design ) services to our managed and franchised hotel owners, generally during the period prior to a hotel s opening or during the period a hotel is converting to a Marriott brand (the pre-opening period ). As compensation for such services, we may be entitled to receive a one-time fixed fee that is payable during the pre-opening period of the hotel. As these services are not a distinct performance obligation, we recognize the fees on a straight-line basis over the initial term of the management or franchise agreement within the Owned, leased, and other revenue caption of our Income Statements. Under our Loyalty Programs, we have a performance obligation to provide or arrange for the provision of goods or services for free or at a discount to Loyalty Program members in exchange for the redemption of points earned from past activities. We have multi-year agreements for our co-brand credit cards associated with our Loyalty Programs. Under these agreements, we have performance obligations to provide a license to the intellectual property associated with our brands and marketing lists ( Licensed IP ) to the financial institution that issues the credit cards, to arrange for the redemption of Loyalty Program points and to provide free night certificates to cardholders. 8

9 Extended Stay America, Inc. 1Q Q The Company provides a specific room type which includes free WiFi, grab and go breakfast, access to on-site laundry facilities and parking. In evaluating its performance obligation, the Company bundles obligations in addition to the room with the obligation to provide the guest the room itself as the additional items are not distinct and separable since the guest cannot benefit from the additional amenities without the consumed room night. The hotel s obligation to provide the additional items or services are not separately identifiable from the fundamental contractual obligation (i.e., providing the room and its contents). The Company and the guest agree upon a fixed rate at the time of booking; therefore, the sales price is identifiable and allocated to the Company s single performance obligation. Hyatt Hotels Corporation 1Q Q Systemwide services We provide sales, reservations, technology, and marketing services on behalf of owners of managed and franchised properties. The promise to provide systemwide services is not a distinct performance obligation because it is attendant to the license of our IP. Therefore, the promise to provide systemwide services is combined with the license of our IP to form a single performance obligation. Hotel management agreement services We provide hotel management agreement services, which form a single performance obligation that qualifies as a series, under the terms of our management agreements. Loyalty program administration We administer a loyalty program for the benefit of the Hyatt portfolio of properties owned, managed, franchised, or licensed by us. Under the program, members earn loyalty points that can be redeemed for future products and services. Points earned by loyalty program members represent a material right to free or discounted goods or services in the future. The loyalty program has one performance obligation that consists of marketing and managing the program and arranging for award redemptions by members. Room rentals and other services provided at owned and leased hotels We provide room rentals and other services to our guests, including but not limited to spa, laundry, and parking. These products and services each represent individual performance obligations. Under our franchise agreements, we also receive initial fees from third-party hotel owners. The initial fees do not relate to a distinct performance obligation and, therefore, are combined with the royalty fees and recognized through management, franchise, and other fees over the expected customer life, which is typically the initial term of the agreement. 9

10 Hilton Worldwide Holdings Inc. 1Q Q We identified the following performance obligations in connection with our management and franchise contracts: Intellectual Property ("IP") licenses grant the right to access our hotel system IP, including brand IP, reservations systems and property management systems. Hotel management services include providing day-to-day management services of the hotels for the property owners. Development services include providing consultative services (e.g., design assistance and contractor selection) to the property owner to assist with the construction of the hotel prior to the hotel opening. Pre-opening services include providing services (e.g., advertising, budgeting, e-commerce strategies, food and beverage testing) to the property owner to assist in preparing for the hotel opening. Material Right A contract may contain an option to acquire additional goods or services. A separate performance obligation could exist if the option provides a material right to the customer that it would not receive without entering into that contract. Material right obligations must be separately valued to allocate part of the transaction price to those specific performance obligations. Management judgment will be required in making this determination. The identification of a material right affects the pattern of revenue recognition in Step 5. Loyalty Programs Many companies have loyalty programs that allow customers to earn points from various activities. Points can be redeemed for different rewards, such a free hotel stay or other third-party merchandise. Currently, many companies apply a cost accrual method to account for the loyalty points they are issuing to customers. Under ASC 606, loyalty points should be accounted for as a separate performance obligation if they provide the customer with a material right. This often will result in the allocation and deferral of revenue related to the material right. 10

11 Hyatt Hotels Corporation 1Q Q Points earned by loyalty program members represent a material right to free or discounted goods or services in the future. We administer the loyalty program for the benefit of the Hyatt portfolio of properties owned, operated, managed, franchised, or licensed by us during the period of their participation in the loyalty program. The loyalty program is primarily funded through contributions from eligible revenues from loyalty program members, and the funds are used for the redemption of member awards associated with the loyalty program and payment of operating expenses. The costs of operating the loyalty program, including the estimated cost of award redemption, are charged to the participating properties based on members' qualified expenditures. The revenues received from the properties are deferred, and revenue is recognized as loyalty points are redeemed, net of redemption expense, through revenues for the reimbursement of costs incurred on behalf of managed and franchised properties. Operating costs are expensed as incurred through costs incurred on behalf of managed and franchised properties. The loyalty program has one performance obligation that consists of marketing and managing the program and arranging for award redemptions by members. The costs of operating the loyalty program are charged to the properties through an assessment fee based on members qualified expenditures. The assessment fee is billed and collected monthly, and the revenue received by the program is deferred until a member redeems points. Upon redemption of points at managed and franchised properties, we recognize the previously deferred revenue through revenues for the reimbursement of costs incurred on behalf of managed and franchised properties, net of redemption expense paid to managed and franchised hotels, as we are an agent in the transaction. Series Provision The series provision is a concept introduced in ASU and does not exist in current generally accepted accounting principles (GAAP). The series provision requires goods or services to be accounted for as a single performance obligation in certain instances, even though the underlying goods or services are distinct. A series of distinct goods or series should be accounted for as a single performance obligation if they are substantially the same, have the same pattern of transfer and both of the following criteria are met: Each distinct good or service in the series represent a performance obligation that will be satisfied over time The entity would measure its progress toward satisfaction of the performance obligation using the same measure of progress for each distinct good or service in the series Entities will need to determine whether a single performance obligation is created in this manner to appropriately allocate variable consideration and apply the guidance on contract modification and changes in transaction price. This provision prevents an entity from having to allocate the transaction price on a relative standalone selling price basis to each increment of a distinct service in repetitive service contracts. If the nature of the promise is the delivery of a specified quantity of a service, the evaluation should consider whether each service is distinct and substantially the same. If the nature of the entity s promise is the act of standing ready or providing a single service for a period of time, the evaluation likely would focus on whether each time increment rather than the underlying activities is distinct and substantially the same. The underlying activities may vary within a day and from day to day, but that should not prevent an entity from concluding the service is distinct and substantially the same. 11

12 Hilton Worldwide Holdings Inc. 1Q Q Each of the identified performance obligations related to management and franchise revenues is considered to be a series of distinct services transferred over time. While the underlying activities may vary from day to day, the nature of the promises are the same each day, and the property owner can independently benefit from each day's services. Step 3: Determine the Transaction Price Revenues are recorded at the transaction price, which is the amount the entity expects to be entitled to and which may be net of amounts paid on behalf of others, discounts and allowances, as applicable. To determine the transaction price, an entity would consider the terms of the contract, its customary business practices and the effects of the time value of money, noncash consideration and consideration payable to the customer. Consideration may include fixed amounts, variable amounts or both. Franchise arrangements often include payments that vary depending on certain tasks being performed or results being accomplished. It is important for hospitality companies to determine the amount of variable consideration they believe they will receive from each contract using historical data and current expectations. Transaction Price Total Amount of Consideration to Which an Entity Expects to Be Entitled Variable consideration Constraining estimates of variable consideration Significant financing Noncash consideration Consideration payable to a customer Variable Pricing & Constraint ASC 606 requires that variable consideration be included in the transaction price if it is probable subsequent changes in the estimate would not result in a significant reversal of revenue. This concept is commonly referred to as the constraint. Entities should perform a qualitative assessment that takes into account the likelihood and magnitude of a potential revenue reversal. The ASU provides factors that could indicate an estimate of variable consideration is subject to significant reversal, e.g., susceptibility to factors outside the entity s influence, a long period before uncertainty is resolved, limited experience with similar types of contracts, practices of providing concessions or a broad range of possible consideration amounts. This estimate would be updated in each reporting period to reflect changes in facts and circumstances. When the transaction price includes a variable amount, an entity must estimate the variable consideration by using either an expected value (probability-weighted) approach or most likely amount approach, whichever is more predictive of the amount to which the entity expects to be entitled. Domino s Pizza, Inc. 1Q Q The Company also offers profit sharing rebates and volume discounts to its supply chain customers. Obligations for profit sharing rebates are calculated each period based on actual results of its supply chain centers and are recognized as a reduction to revenue. Volume discounts are based on annual sales. Each period, the Company estimates the amount that will be earned and records a reduction to revenue. 12

13 Extended Stay America, Inc. 1Q Q Franchise and management fees are based on a percentage of hotel revenues and, as a result, fees vary from period to period. Due to the fact that a portion of fees associated with a typical hotel management agreement are expected to be categorized as variable consideration, the estimate of the transaction price associated with these fees is determined in accordance with guidance on variable consideration and constraining estimates of variable consideration. In the event that fees include variables that extend beyond the current period, the Company uses the most likely amount method to determine the amount of revenue to record based on a reasonable revenue forecast for the applicable hotel. The Company does not expect to have constraining estimates, as hotel revenue is obtained monthly and used to calculate the fees. Hyatt Hotels Corporation 1Q Q Hotel management agreement services In exchange for providing these services, we receive variable consideration in the form of management fees, which are comprised of base and incentive fees. Incentive fees are typically subject to the achievement of certain annual profitability targets, and therefore, we apply judgment in determining the amount of incentive fees recognized each period. Incentive fees revenue is recognized to the extent it is probable that we will not reverse a significant portion of the fees in a subsequent period. We rely on internal financial forecasts and historical trends to estimate the amount of incentive fees revenue recognized and the probability that incentive fees will reverse in the future. Hilton Worldwide Holdings Inc. 1Q Q Incentive fees are generally based on a percentage of a hotel's operating profits and in some cases may be subject to a stated return threshold to the property owner, normally over a one-calendar year period (the "incentive period"). Incentive fee revenue is recognized on a monthly basis, but only to the extent the cumulative fee earned does not exceed the probable fee for the incentive period. Significant Financing Component Contract terms may explicitly or implicitly provide the entity or the customer with favorable financing terms. The transaction price should reflect a selling price as though the customer had paid cash at the time of transfer and should be adjusted to reflect the time value of money if there is a significant financing component. An entity should consider the following: If the consideration would differ substantially if the customer paid cash promptly under typical credit terms Expected length of time between delivery of goods or services and receipt of payment The interest rate in the contract and prevailing market interest rates ASU 606 makes an exception for certain differences between the promised consideration and the cash selling price of the goods or services. A contract would not be considered to have a significant financial component if the difference stems from a reason other than financing to either the customer or contractor and the difference is proportional to the reason for the difference. As a practical expedient, an entity would not reflect the time value of money if the period between customer payment and transfer of goods or services is one year or less. This also would apply to contracts greater than one year if the period between performance and the corresponding payment for that performance is one year or less. Disclosure is required if this practical expedient is elected. 13

14 Hilton Worldwide Holdings Inc. 1Q Q Application, initiation and other fees are typically fixed and collected upfront and are recognized as revenue over the term of the franchise contract. We do not consider this advance consideration to include a significant financing component, since it is used to protect us from the property owner failing to adequately complete some or all of its obligations under the contract. We do not adjust the promised amount of consideration for the effects of a significant financing component when we expect, at contract inception, that the period between our transfer of a promised good or service to a customer and when the customer pays for that good or service will be one year or less, which it is in substantially all cases. Additionally, we do not typically include extended payment terms in our contracts with customers. Noncash Consideration Noncash consideration refers to contracts that include promises of consideration in a form other than cash, e.g., equity, advertising, etc. If a customer promises consideration in a form other than cash, an entity would measure the noncash consideration at fair value at contract inception to determine the transaction price. If a reasonable estimate of fair value of the noncash consideration cannot be made, the entity would use the estimated selling price of the promised goods or services, similar to current accounting standards. Yum! Brands, Inc. 1Q Q Additionally, from time-to-time we provide non-refundable consideration to franchisees in the form of cash or other incentives (e.g. cash payments to incent new unit openings and free or subsidized equipment). The Company s intent in providing such consideration is to drive new unit development or same-store sales growth that will result in higher future revenues for the Company. Under Legacy GAAP, these payments were recognized when we were obligated to make the payment and were presented as either a reduction to Franchise and property revenues, if cash was provided directly to the franchisee, or as Franchise and property expenses, if cash was not provided directly to the franchisee. Upon adopting Topic 606, such payments are capitalized as assets and amortized as a reduction in Franchise and property revenues over the period of expected cash flows from the franchise agreements to which the payment relates. Hilton Worldwide Holdings Inc. 1Q Q Franchise fees are reduced by any consideration paid or anticipated to be paid to incentivize hotel owners to enter into franchise contracts. Step 4: Allocate the Transaction Price to Performance Obligations An entity would allocate the transaction price to performance obligations based on the relative standalone selling price of separate performance obligations. The best evidence of standalone selling price would be the observable price for which the entity sells goods or services separately. In the absence of separately observable sales, the standalone selling price would be estimated by using observable inputs and considering all information reasonably available to the entity. Several approaches could be used adjusted market assessment, cost plus margin or residual value. The new standard does not specify how to determine the standalone selling price. Loyalty Programs If customer loyalty points represent a distinct performance obligation, a company will need to estimate the standalone selling price of the points. If the standalone selling price for loyalty points is not directly observable, an 14

15 entity should estimate it. That estimate should reflect the discount the customer would obtain when exercising the option, adjusted for both of the following: Any discount the customer could receive without exercising the option The likelihood that the option will be exercised If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services, an entity may as a practical alternative to estimating the standalone selling price of the option allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Hilton Worldwide Holdings Inc. 1Q Q When points are earned by Hilton Honors members, they are provided with a material right to free or discounted goods or services in the future upon accumulation of the required level of Hilton Honors points. Points may be redeemed for the right to stay at participating properties, as well as for other goods and services from third parties. As the points are issued to a Hilton Honors member, the property or affiliated partner pays Hilton Honors based on an estimated cost per point for the costs of operating the program, which include marketing, promotion, communication and administrative expenses, as well as the estimated cost of award redemptions. We record liabilities for the payments received from participating hotels and program partners. Amounts equal to the estimated cost per point of the future redemption obligation are included in the liability for guest loyalty program and any amounts received in excess of the estimated cost per point are included in deferred revenues in our consolidated balance sheets. We engage outside actuaries to assist in determining the fair value of the future redemption obligation using statistical formulas that project future point redemptions based on factors that include historical experience, an estimate of points that will eventually be redeemed, which includes an estimate of "breakage" for points that will never be redeemed, and the cost of reimbursing properties and other third parties in respect to other redemption opportunities available to members. When points are issued as a result of a stay at our owned or leased hotel, we recognize a reduction in owned and leased hotel revenues, since we are also the guest loyalty program sponsor. For the Hilton Honors fees that are charged to the participating properties, we allocate the fees to the material right created by Hilton Honors points issued using the variable consideration allocation guidance, since the fees are directly related to the issuance of Hilton Honors points to the Hilton Honors member and Hilton's efforts to satisfy the future redemption of those Hilton Honors points. The transaction prices for the Hilton Honors points are reduced by the expected payments to the third parties that will provide the free or discounted room or service using the actuarial projection of the cost per point. The remaining transaction price is then further allocated to the points that are expected to be redeemed, adjusting the points that are issued for estimated breakage, and recognized when those points are redeemed. While the points are outstanding, both the estimate of the expected payments to third parties (cost per point) and the estimated breakage are reevaluated, and the amount of revenue recognized when each point is redeemed is adjusted so that the final amount allocated to the material right is reflective of the amount retained for providing all of the free or discounted goods and services, net of the payments to third parties and points not redeemed. Allocating Discounts Discounts for a bundle of goods or services would be allocated to all performance obligations unless all of the following criteria are met, in which case the entire discount would be allocated to one or more (but not all) separate performance obligations: The entity regularly sells each good or service or each bundle of goods or services in the contract on a standalone basis The entity regularly sells on a standalone basis bundles of distinct goods or services at a discount to the standalone selling prices of the goods or services in each bundle 15

16 The observable selling prices from those standalone sales provide evidence of the performance obligations to which the entire discount belongs Hyatt Hotels Corporation 1Q Q If a guest enters into a package including multiple goods or services, the fixed price is allocated to each distinct good or service based on the stand-alone selling price for each item. In exchange for the products and services provided, we receive fixed and variable consideration that is allocated between the performance obligations based upon the relative stand-alone selling prices. Significant judgment is involved in determining the relative stand-alone selling prices, and therefore, we engaged a third-party valuation specialist to assist us. Co-branded credit card We have a co-branded credit card agreement with a third party and under the terms of the agreement, we have various performance obligations: granting a license to the Hyatt name, arranging for the fulfillment of points issued to cardholders through the loyalty program, and awarding cardholders with free room nights upon achievement of certain program milestones. The loyalty points and free room nights represent material rights that can be redeemed for free or discounted services in the future. We utilized a relief from royalty method to determine the revenue allocated to the license, which is recognized over time. We utilized observable transaction prices and adjusted market assumptions to determine the standalone selling price of a loyalty point and we utilized a cost plus margin approach to determine the stand-alone selling price of the free room nights. Hilton Worldwide Holdings Inc. 1Q Q The majority of our performance obligations are a series of distinct goods or services, for which we receive variable consideration through our management and franchise fees or fixed consideration through our owned and leased hotels. We allocate the variable fees to the distinct services to which they relate applying the prescribed variable consideration allocation guidance, and we allocate fixed consideration to the related performance obligations based on the present value of the allocated variable cash flows. Although the transaction prices of room rentals, goods and other services are generally fixed and based on the respective room reservation or other agreement, an estimate to reduce the transaction price is required if a discount is expected to be provided to the customer. For package reservations, the transaction price is allocated to the performance obligations within the package based on the estimated standalone selling prices of each component. On occasion, the hotel may also provide the customer with a material right to a free or discounted good or service in conjunction with a room reservation or banquet contract (e.g., free breakfast and free room night for every four nights booked). These material rights are considered separate performance obligations to which a portion of the transaction price is allocated based on the estimated standalone selling prices of the good or service, adjusted for the likelihood the hotel guest will exercise the right. The co-brand license fee is allocated between two performance obligations based on their estimated standalone selling prices: (i) an IP license using the relief-from-royalty method; and (ii) material rights for free or discounted goods or services to the credit card customers using a cost plus method based on an evaluation of other thirdparty administrators. 16

17 Marriott International, Inc. 1Q Q We have multi-year agreements for our co-brand credit cards associated with our Loyalty Programs. Under these agreements, we have performance obligations to provide a license to the intellectual property associated with our brands and marketing lists ( Licensed IP ) to the financial institution that issues the credit cards, to arrange for the redemption of Loyalty Program points as discussed in the preceding paragraph, and to provide free night certificates to cardholders. We receive fees from these agreements, including fixed amounts that are primarily payable at contract inception, and variable amounts that are paid to us monthly over the term of the agreements, based on: (1) the number of free night certificates issued and redeemed; (2) the number of Loyalty Program points purchased; and (3) the volume of cardholder spend. We allocate those fees among the performance obligations, including the Licensed IP, our Loyalty Program points, and free night certificates provided to cardholders based on their estimated standalone selling prices. The estimation of the standalone selling prices requires significant judgments based upon generally accepted valuation methodologies regarding the value of our Licensed IP, the amount of funding we will receive, and the number of Loyalty Program points and free night certificates we will issue over the term of the agreements. We base our estimates of these amounts on our historical experience and expectation of future cardholder behavior. We recognize the portion of the Licensed IP revenue that meets the sales-based royalty criteria as the credit cards are used and the remaining portion of the Licensed IP revenue on a straight-line basis over the contract term. In our Income Statements, we primarily recognize Licensed IP revenue in the Franchise fees caption, and we recognize a portion in the Cost reimbursement revenue caption. We recognize the revenue related to the Loyalty Program points as discussed in the preceding paragraph. We recognize the revenue related to the free night certificates when the related service is provided. If the free night certificate redemption involves a managed or franchised property, we recognize revenue net of the redemption cost, as our performance obligation is to facilitate the transaction between the Loyalty Program member and the managed or franchised property. Step 5: Recognize Revenue Under ASC 606, an entity recognizes revenue when (or as) a performance obligation is satisfied by transferring a promised good or service to a customer. For performance obligations satisfied at a point in time, the associated revenue would be recognized at that point in time. For performance obligations satisfied over time, an entity must choose a recognition method that best depicts the transfer of goods or services. Deciding the appropriate recognition pattern may require significant management judgment. Conclusions will depend on a company s unique facts and circumstances and should be properly documented for an auditor s and/or regulator s review. Recognize revenue when control transfers Over time Point in time Input or output progress measure Determine when control transfers 17

18 Performance Obligations Satisfied over Time An entity transfers control over time if any of the following criteria are met: The customer receives and consumes the benefits of the entity s performance as the entity performs, e.g., a cleaning service The customer controls the asset as it is created or enhanced by the entity s performance (could be tangible or intangible) The entity s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date Control Transferred at a Point in Time Performance obligations that do not meet any of the three criteria for being satisfied over time should be accounted for at a point in time. When control over an asset is transferred at a single point in time, an entity would recognize revenue by evaluating when the customer obtains control. An entity would use judgment in determining when control has been transferred, considering the following indicators: The entity has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset The AICPA task force concluded that hotel room-only reservations are performance obligations satisfied over time as the hotel guest simultaneously receives and consumes the benefits provided by the hotel. Most ancillary goods or services do not meet the criteria to be a performance obligation recognized over time. Hyatt Hotels Corporation 1Q Q Spa and fitness revenue is recognized at the point in time the products or services are provided to the customer. Hilton Worldwide Holdings Inc. 1Q Q Material rights for free or discounted goods or services to hotel guests are satisfied at the earlier point in time of either when the material right expires or the underlying free or discounted good or service is provided to the hotel guest. We satisfy our performance obligation related to points issued under the Hilton Honors guest loyalty program at a point in time when points are redeemed for a free good or service by the Hilton Honors member. Licensing & Rights to Use Intellectual Property Licensing refers to granting a customer the right to use but not own intellectual property (IP). Examples include patents, trademarks, software, franchises and motion pictures. Licensing arrangements have a variety of forms term-based or perpetual, exclusive or nonexclusive and payment terms can be fixed, variable, upfront or installment. An entity must first determine if the license is distinct from other goods or services in the 18