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

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

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3 To our clients and To our clients and other friends The Financial Accounting Standard Board (the FASB) and the International Accounting Standards Board (the IASB) (collectively, the Boards) have jointly issued a proposed standard to supersede virtually all existing revenue guidance under US GAAP and IFRS. Generally, the Boards believe the new revenue model will accomplish the following: Remove the inconsistencies and weaknesses that currently exist in US GAAP Provide a framework for addressing revenue recognition issues Improve comparability of revenue recognition practices among industries, entities within those industries, jurisdictions and capital markets Reduce the complexity of applying revenue recognition guidance by reducing the volume of the relevant guidance Revenue is defined under current US GAAP as inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services or other activities that constitute the entity s ongoing major or central operations. 1 While this single definition of revenue exists, the authoritative guidance for revenue recognition in the Accounting Standards Codification (ASC) was codified from more than 200 individual pieces of literature issued by multiple standard setters. Most of the existing US GAAP guidance is specific to certain transactions or certain industries, which has resulted in numerous individual standards focused on very detailed matters. However, many other topics within revenue recognition lack guidance or the existing guidance is unclear. The proposed guidance specifies the accounting for all revenue arising from contracts with customers and affects all entities that enter into contracts to provide goods or services to their customers (unless those contracts are in the scope of other US GAAP requirements). In addition, the existing requirements for the recognition of gains and losses on the sale of certain nonfinancial assets, such as property and equipment, would be amended by the proposed standard in order to be consistent with the measurement and recognition principles in the proposed revenue model. The proposed guidance outlines the principles that an entity would apply in order to report decision-useful information regarding the measurement and timing of revenue and the related cash flows. The core principle in the proposed standard is that an entity will recognize revenue to depict the transfer of goods or services to customers at an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. The principles in the proposed standard are applied using the following five steps: 1. Identify the contract(s) with a customer 2. Identify the separate performance obligations in the contract 3. Determine the transaction price 1 FASB Concepts Statement No. 6, Elements of Financial Statements (CON 6) Financial reporting developments The road to convergence: the revenue recognition proposal

4 To our clients and other friends 4. Allocate the transaction price to the separate performance obligations 5. Recognize revenue when the entity satisfies each performance obligation An entity will be required to exercise judgment when considering the terms of the contract(s) and all surrounding facts and circumstances, including implied contract terms, when applying the proposed model. Further, an entity must apply the requirements of the proposed model consistently to contracts with similar characteristics and in similar circumstances. The Boards are proposing that companies adopt the new guidance retrospectively for all periods presented in the period of adoption. The proposal does not include a proposed effective date. Instead, the effective date will be considered as part of another project on the effective dates for all of the major joint projects currently under way and expected to be completed in We have issued this publication to highlight some of the more significant implications of the proposed revenue recognition model. In the coming weeks, we also will provide certain industry-specific publications that will address, in further detail, the complexities and subtleties that may give rise to significant changes to practice in those industries. We encourage preparers and users of financial statements to read this publication and the forthcoming supplements carefully and consider the potential effects of the proposed model on existing revenue recognition practices. The issues discussed in this publication are intended to assist companies in formulating feedback to the Boards that can help in the development of a highquality final standard. The discussions within this publication represent preliminary thoughts and additional issues may be identified through continued analysis of the exposure draft (ED) and as the elements of the ED change on further deliberation by the Boards. The comment letter period ends on 22 October 2010 and the Boards also plan to hold public roundtable meetings following the comment period to gather information and obtain the views of interested parties about the proposed guidance. Interested parties should refer to the ED on either of the Boards websites for instructions on submitting comment letters and registering for the roundtable events. August 2010 Financial reporting developments The road to convergence: the revenue recognition proposal

5 Contents Contents Chapter 1: Scope, transition and internal control considerations Scope Transition Internal control considerations... 4 Chapter 2: Identify the contract with the customer Combination and segmentation of contracts Contract modifications Chapter 3: Identify the separate performance obligations in the contract Distinct goods and services Product warranties Quality assurance warranties Insurance warranties Differentiating between quality assurance and insurance warranties Combination warranties Warranty costs Principal versus agent considerations Consignment arrangements Customer options for additional goods Sale of products with a right of return Chapter 4: Determine the transaction price Variable consideration Collectibility Time value of money Noncash consideration Consideration paid or payable to a customer Nonrefundable upfront fees Chapter 5: Allocate the transaction price to the separate performance obligations Estimating standalone selling prices Changes in transaction price subsequent to contract inception Chapter 6: Satisfaction of performance obligations Continuous transfer of goods and services Recognizing revenue when a right of return exists Repurchase agreements Written put option held by the customer Forward or call option held by the entity Licensing and rights to use Bill-and-hold arrangements Customer acceptance Financial reporting developments The road to convergence: the revenue recognition proposal i

6 Contents Chapter 7: Other measurement and recognition topics Onerous performance obligations Contract costs Sale of nonfinancial assets Chapter 8: Presentation and disclosure Presentation Contract assets and contract liabilities Disclosure Disaggregation of revenue Reconciliation of contract balances Performance obligations Onerous performance obligations Significant judgments in the application of the new standard Financial reporting developments The road to convergence: the revenue recognition proposal

7 Chapter 1: Scope, and internal control considerations Chapter 1: Scope, transition and internal control considerations 1.1 Scope The scope of the Boards proposed guidance on revenue recognition includes all contracts with customers to provide goods or services in the ordinary course of business. However, the following contracts have been excluded from the scope of the proposed guidance: Lease contracts within the scope of Accounting Standards Codification (ASC) on leases Insurance contracts within the scope of ASC on insurance Contractual rights or obligations (i.e., financial instruments) such as receivables, debt and equity securities and derivatives 4 Guarantees (other than product warranties) within the scope of ASC 460, Guarantees Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers other than the parties to the exchange 5 Entities will likely enter into transactions that are partially within the scope of the proposed revenue recognition guidance and partially within the scope of other guidance. In their basis for conclusions, the Boards noted that it would not be appropriate to account for such contracts in their entirety under one standard or another. The Boards explain that different accounting outcomes could result depending on whether the goods or services were sold on a standalone basis or together with other goods and services. Under the proposed guidance, if a contract is partially within the scope of the proposed revenue guidance and partially within the scope of other guidance, entities would apply the separation and measurement requirements of the other guidance first. If the other guidance does not specify how to separate and initially measure any parts of the contract, the entity would apply the proposed revenue recognition guidance to separate and initially measure those parts of the contract. 2 ASC 840, Leases 3 ASC 944, Financial Instruments Insurance 4 This exclusion includes contracts within the scope of the following ASC Topics: ASC 310, Receivables; ASC 320, Investments Debt and Equity Securities; ASC , Extinguishments of Liabilities; ASC 470, Debt; ASC 815, Derivatives and Hedging; ASC 825, Financial Instruments; and ASC 860, Transfers and Servicing. 5 Refer to ASC 845, Nonmonetary Transactions Financial reporting developments The road to convergence: the revenue recognition proposal 1

8 Chapter 1: Scope, transition and internal control considerations Entities entering into transactions that fall within the scope of multiple areas of accounting guidance currently have to separate those transactions into the elements that are accounted for under different pieces of literature. The ED does not propose to change this requirement, nor does it change how the appropriate separation model is determined (e.g., which accounting model is used to separate elements subject to different literature); therefore, we do not expect a significant change in practice. However, under current US GAAP revenue transactions are separated into elements that are accounted for under different pieces of revenue guidance (e.g., a multiple-element transaction that falls within the scope of both the multiple-element arrangements guidance in ASC and the construction-type and production-type arrangements guidance in ASC ). Under the proposed guidance, this separation would not be required as there would be a single revenue recognition model. Interaction with the current joint project on leases The Boards are currently working on a joint leasing project for which an ED was issued on 17 August In many respects, the proposed performance obligation and derecognition models for lessor accounting within the expected leasing model are consistent with the principles in the proposed revenue model. For example, the requirement to continually assess the amounts of expected variable consideration is consistent between the models. Another similarity includes the determination of whether the risks or benefits have transferred to the lessee under the leasing model, which would then require accounting under the derecognition model (i.e., similar to a sale). This compares to the concept of transfer of control under the revenue model. However, some aspects of the proposed leasing model are notably different from the proposed revenue model. The most significant difference relates to the recognition of a gross asset (for the right to receive future lease payments) and a gross liability (for the obligation to permit the lessee to use the leased asset). Under the proposed revenue model, contract assets and liabilities are not recorded at contract inception (i.e., they are deemed to be equal and net to zero) and would only be recorded when one party to the contract performs under the contract before the other party (see Section 8.1). Under current US GAAP, revenue accounting and the accounting for leases by lessors is very similar, particularly with respect to the recognition of assets and liabilities for leased assets in operating leases. We believe that the proposed gross recognition of assets and liabilities under the leasing model will require an increased emphasis on determining whether a contract with a customer is a lease that is within the scope of the leasing guidance. 2 Financial reporting developments The road to convergence: the revenue recognition proposal

9 Chapter 1: Scope, transition and internal control considerations Interaction with the current joint project on insurance contracts The Boards are also deliberating 6 a joint project on accounting for insurance contracts. Based on the Boards current views, we believe the concepts of the expected insurance model are similar to the proposed revenue model. However, there are a handful of significant differences that will require entities to challenge whether certain contracts fall within the scope of the insurance model or the revenue model. One significant difference in the proposed models relates to the timing of the recognition of a contract. In some cases, a contract may exist under the proposed insurance model that would not exist under the proposed revenue model. Under the proposed insurance model, a noncancelable offer by an insurer to its customer is a triggering event that creates a contract that must be accounted for. Under this model, the offer itself exposes the insurer to risk and the customer s acceptance of the offer is generally not required for the insurer to be at risk. Under the revenue model, one of the four criteria for a contract is that all parties have approved the contract and are committed to satisfying their respective obligations (see Chapter 2). Another potential difference between the two models is the contract boundaries for those contracts within the scope of each respective model. In the proposed insurance model, renewal periods in which the insurer does not have the right to re-underwrite and re-price are included in initial determination of the estimated transaction price and contract period for purposes of measuring the contract. Conversely, under the proposed revenue guidance, while renewal options are considered deliverables to which transaction consideration is allocated at the inception of the contract (when and if those renewal options are deemed to provide a material right to the customer), consideration is allocated only to the right to purchase, not that actual good or service obtainable upon the exercise of the option (see Section 3.5). The accounting for contract acquisition costs will also vary between the two proposed models. Under the proposed insurance guidance, the incremental cash outflows associated with the acquisition of a contract become a component of the measurement of the policy liability (fulfillment cash flows) that are recognized in income over time as the obligations of the insurer are satisfied. Conversely, under the proposed revenue model all costs incurred to acquire a contract (e.g., commissions) are expensed as incurred (see Section 7.2). Finally, the presentation of revenue and costs of revenue for insurance contracts will differ significantly from the presentation of revenue under the proposed model. Rather than presenting revenue and cost of revenue separately in the statement of comprehensive income, the proposed insurance model will require the recognition of only the margin on the contract. 6 The IASB issued its exposure draft on accounting for insurance contracts on 30 July 2010; however, the FASB has not yet issued its exposure document. Financial reporting developments The road to convergence: the revenue recognition proposal 3

10 Chapter 1: Scope, transition and internal control considerations 1.2 Transition The Boards concluded that the proposed guidance should be applied retrospectively in accordance with ASC 250 7, which they believe will provide the users of financial statements with useful comparative information for each year presented. While the Boards noted that retrospective application could be burdensome for some entities, particularly those with a large number of long-term arrangements, they ultimately rejected a prospective or limited retrospective basis of adoption. The Boards believed that a prospective method of adoption would not provide decision-useful information because the recognition and measurement principles being applied to new contracts would not be comparable to those applied to existing contracts. While the Boards also considered the possibility of limited retrospective adoption, they were unable to identify a specific date for limiting the retrospective application of the proposed guidance that would, on a cost-beneficial basis, be preferable to full retrospective application. The Boards ultimately concluded that the ability to apply the exceptions to retrospective application under ASC 250 and the expected considerable time between the issuance of a final standard and its effective date (which has not yet been proposed) will provide users the time and flexibility necessary to apply the proposed guidance retrospectively. We believe the effort required to adopt this standard will be significant for companies in many industries, including media & entertainment and software (where long-term licenses are common), long-term construction and for all other entities that have performance obligations requiring an extended period to fulfill. The Boards acknowledge in the basis for conclusions that retrospective application may be burdensome for some preparers, particularly those with many long-term contracts. Additionally, to adopt the proposed guidance retrospectively, an entity will prepare all estimates based on information known at the inception of the contract or, as applicable, during the course of the contract when estimates are revised based on new information. We believe, and the Boards also acknowledge, that estimating the transaction price without using hindsight (i.e., based on actual experience with collectibility and variable consideration) and estimating standalone selling prices will be difficult for many entities. 1.3 Internal control considerations When considering the potential effects of the proposed revenue recognition model, entities should consider not only the potential changes in accounting policies and accounting systems (which will be significant for many entities), but the related changes needed in internal control processes and procedures as well. The increased use of principles and reduction of prescriptive guidance within the proposed model will require entities to use estimation and 7 ASC 250, Accounting Changes and Error Corrections 4 Financial reporting developments The road to convergence: the revenue recognition proposal

11 Chapter 1: Scope, transition and internal control considerations judgment in more areas than under today's guidance. For example, significant new estimates and judgments could include: Whether a good or service includes a distinct profit margin and otherwise meets the requirements to represent a performance obligation (see Section 3.1) Estimated standalone selling price of performance obligations that are not sold separately (see Section 5.1) Variable consideration (e.g., royalties, milestone payments, payments for optional services) included in the initial estimate of the transaction consideration (see Section 4.1) Onerous performance obligations (see Section 7.1) Estimation processes typically have higher levels of inherent risk associated with them than routine data processes and, therefore, require increased internal controls. While these changes will affect all entities, public reporting entities subject to the internal control evaluation and reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002 ("Section 404") will have to be prepared to report on these changes in internal control as well as continue assessing whether or not internal control over financial reporting remains effective. Further, as many of the proposed disclosure requirements (discussed further in Chapter 8) represent new disclosures compared to today's requirements, these increased disclosures will likely also expand the Section 404 assessment. Financial reporting developments The road to convergence: the revenue recognition proposal 5

12 Chapter 2: the contract with the customer Chapter 2: Identify the contract with the customer In order to apply the proposed revenue recognition model, an entity must first identify the contract, or contracts, to provide goods and services to its customer. Any contracts that create enforceable obligations fall under the scope of the proposed guidance and they may be written, oral or implied by the entity s customary business practice. The entity s past business practices may influence its determination of whether a contract exists based on whether past practice has created an enforceable obligation. For purposes of applying the proposed guidance, a contract exists only if all of the following criteria are met: The contract has commercial substance (demonstrated when the entity s future cash flows are expected to change as a result of the contract) The parties to the contract have approved the contract and are committed to satisfying their respective obligations The entity can identify each party s enforceable rights regarding the goods or services to be transferred The entity can identify the terms and manner of payment for those goods or services Termination clauses within contracts are an important consideration when determining whether a contract exists. The proposed guidance states that a contract does not exist under the proposed model if either party can terminate a wholly unperformed contract without penalty. Any arrangement in which the entity has not provided the contracted goods or services and the customer has not paid the contracted consideration is considered to be a wholly unperformed contract. Oral or implied agreements Considering oral or implied agreements to be contracts applicable to the proposed model may be a significant change in practice for some entities. Staff Accounting Bulletin (SAB) Topic 13 provides four criteria that must be met for the recognition of revenue, including that persuasive evidence of an arrangement exists. Further, SAB Topic 13 refers to SOP 97-2 (codified in ASC ), which provides guidance on determining whether persuasive evidence of an arrangement exists. Generally, that guidance indicates that if an entity operates in a manner that does not rely on contracts to document formal agreement, some other evidence must exist to document the arrangement (e.g., purchase orders, online authorizations). Additionally, that guidance states that if an entity has a customary business practice of using written contracts to document formal arrangements, evidence of any arrangement exists only by a fully executed contract. 8 ASC , Software Revenue Recognition 6 Financial reporting developments The road to convergence: the revenue recognition proposal

13 Chapter 2: Identify the contract with the customer Example 1 oral contract IT Support Co. provides online technology support for consumers remotely via the internet. For a flat fee, IT Support Co. will scan a customer s personal computer (PC) for viruses, optimize the PC s performance and solve any connectivity problems. In many instances, the customers must call IT Support Co. in order to obtain the services when the customer is experiencing connectivity problems. When the customer calls to initiate the transaction, IT Support Co. describes the services it can provide and states the price for those services. When the customer agrees to the terms stated by the representative, payment is made over the telephone. In this example, IT Support Co. and its customer are entering into an oral agreement for IT Support Co. to repair the customer s PC and for the customer provide consideration by transmitting a valid credit card number and authorization over the telephone. The four criteria above are all met with the last three criterion all met via the telephone conversation and the charge to the customer s credit card. Considerations for change orders in construction-type contracts The proposed model may represent a significant change in practice for unapproved, or partially unapproved (e.g., unpriced) change orders for those construction-type contracts within the scope of ASC Change orders are modifications to a contract that change the provisions of a construction-type contract without adding new provisions. In some cases, the pricing and scope of change orders will be approved by all parties in a timely manner, but the scope of a change order may be agreed to long before the parties agree to certain other details, such as pricing. In some situations, the parties to the contract do not finalize the terms and conditions of the change order until after completion of the contract. Current guidance on contract accounting within US GAAP provides for the consideration of change orders prior to having complete approval (i.e., prior to having a revised contract). If it is probable that the costs will be recovered through a change in the contract price for a partially approved change order, both costs and revenues may be recorded as equal amounts in the period of the change. The costs may also be deferred until all parties agree to the changes. If it is not probable that costs will be recovered through a change in the contract price, the costs are expensed as contract costs in the period incurred (assuming the contract price covers the costs of the change order). Financial reporting developments The road to convergence: the revenue recognition proposal 7

14 Chapter 2: Identify the contract with the customer Under the proposed guidance, an entity only applies the proposed revenue requirements to a contract modification if the four criteria for a contract to exist are met. In any scenario in which terms or conditions are not agreed to by both parties, the change order generally would not be considered a contract for application of the proposed guidance. In this case, any costs that meet the criteria for capitalization will be capitalized; otherwise, the costs would be expensed. However, no revenue is recognized for a change order until the contract criteria are met. This is a change in practice that may result in later recognition of revenue. 2.1 Combination and segmentation of contracts In most cases, entities would apply the five-step model described above to individual contracts with a customer. However, there may be situations in which the entity should combine multiple contracts for purposes of revenue recognition. There also may be situations that require an entity to segment single contracts in applying the proposed model. When two or more individual contracts are linked to one another through price interdependency, the proposed guidance requires an entity to combine those contracts and accounts for them as a single contract. Price interdependency is generally apparent when the amount of consideration promised for goods or services under a contract is dependent on the amount of consideration promised under another contract. Paragraph 13 of the ED provides the following indicators that two or more contracts have interdependent prices: The contracts are entered into at or near the same time The contracts are negotiated as a package with a single commercial objective The contracts are performed either concurrently or consecutively It is important to note that the price of a particular contract is not interdependent with another contract solely because a discount provided within the new contract is based on the existing customer relationship (i.e., because of previous contracts between the two parties). Determining whether multiple contracts contain interdependent pricing requires professional judgment and depends on the facts and circumstance of each arrangement. 8 Financial reporting developments The road to convergence: the revenue recognition proposal

15 Chapter 2: Identify the contract with the customer The current multiple-element arrangements guidance within US GAAP contains a presumption that separate contracts entered into at or near the same time with the same entity or related parties were negotiated as a package and should be evaluated as a single agreement. Further, ASC is clear that the evaluation of whether multiple contracts are treated as a single arrangement considers both the form and substance of an arrangement. Often, vendors have continuing relationships with their customers, and this business relationship will lead to numerous signed or oral arrangements between the two parties. The existence of concurrent agreements suggests that these multiple agreements may represent a single arrangement, and, as such, the timing and measurement of revenue recognition might be affected by the terms of the overall arrangement. Further, ASC (for construction-type and production-type contracts) and ASC (for software transactions) provide guidance on when to combine separate contracts and treat them as a single arrangement. Regardless of the underlying current ASC guidance, the determination of whether to combine contracts requires the use of professional judgment and careful consideration of all facts and circumstances. The three indicators provided in the ED are generally consistent with the underlying principles in the current ASC guidance on combining contracts. As a result, we anticipate the proposed guidance will result in entities reaching similar conclusions about when to combine contracts as they do today. Conversely, an entity may determine that it is necessary to segment a single contract and account for it as two or more contracts if the prices of goods or services promised in the contract are independent of the prices of other goods or services in the contract. Under the proposed model, goods or services are priced independently of other goods or services in the same contract only if both of the following conditions are met: The entity, or another entity, regularly sells identical or similar goods or services separately The customer does not receive a significant discount for buying some goods or services together with other goods or services in the contract Based on the above, one might conclude that if a customer receives a significant discount for buying some goods or services with other goods or services in the contract, the contract should not be segmented. However, in the basis for conclusions, the Boards state that if the entity has evidence that a discount relates only to some goods or services within a contract, then the contract may still meet the criteria for segmentation. This indicates that an entity does not have to assume that a discount for a particular good or service is a result of buying the bundle of goods and services. Financial reporting developments The road to convergence: the revenue recognition proposal 9

16 Chapter 2: Identify the contract with the customer Once an entity determines that segmenting a contract is appropriate, the entity allocates the total expected consideration to each identified segment of the contract in proportion to the standalone selling prices of the goods or services within each identified segment. The transaction price allocated to each segment is then allocated to the individual performance obligations within each segment, as applicable. Subsequent changes in the amount of expected consideration are allocated only to the identified segment to which those changes relate. For example, any changes in the expected consideration due to changes in expected variable consideration are allocated to the segment giving rise to the variability. There is little current US GAAP on segmenting a contract. Criteria for segmenting certain long-term production-type or construction-type contracts exist within the guidance on construction-type and production-type contracts in ASC , but segmenting generally is considered optional, not mandatory, under that guidance. As a result, the concept of segmenting a contract will likely be new to most entities. However, it is unclear how frequently entities would actually segment a contract under the proposed guidance, as it seems unlikely that the criteria discussed above would be met frequently. Further, in those scenarios where the criteria are met, it seems less likely that segmenting the contract will provide a different accounting result than simply identifying separate performance obligations. The following scenarios illustrate this point. Example 2 segmenting a contract Assume Company Z enters into a single contract to sell a handheld electronic gaming device and two games for $300. Company Z determines that the handheld device and both games are each distinct based on the proposed guidance; therefore, each product represents a separate performance obligation under the contract. The standalone selling prices of the handheld device and each game are $250, $25 and $25, respectively. Company Z sells the three products separately and the customer is not receiving a significant discount by purchasing the goods together. In this scenario, the contract meets the criteria to be segmented; however, the treatment of the handheld device and two games as three individual contracts (segments) or as three separate performance obligations under one contract has no effect on the amount of promised consideration allocated to each performance obligation and, accordingly, no effect on the timing of the revenue recognized. That is, regardless of whether consideration is allocated to three contract segments or three performance obligations, the allocation is performed on a relative selling price basis. 10 Financial reporting developments The road to convergence: the revenue recognition proposal

17 Chapter 2: Identify the contract with the customer Assume the same fact pattern as above, except that the customer is eligible to receive a $30 rebate on the handheld device if the customer submits the appropriate paperwork. Company Z provides this same rebate offer to customers purchasing the handheld on a standalone basis. In this fact pattern, because the $30 in variable consideration is attributable only to the handheld device, segmenting the contract may affect the timing of revenue recognition. If Company Z segments the contract, the adjustment to the estimated transaction price resulting from the probability-weighted expected rebate redemptions is allocated in its entirety to the handheld device. Conversely, if Company Z concludes the contract should not be segmented, the adjustment to the estimated transaction price resulting from the rebate is allocated to all three performance obligations based on relative standalone selling price (discussed further below in Section 5.2). 2.2 Contract modifications When the parties modify a contract subsequent to contract inception, the entity must determine whether the modification creates a new contract or whether the contract modification should be combined with the existing contract. A contract modification is described in the proposed guidance as any change in the scope or price of a contract, initiated by any party to the contract. Paragraph 17 of the ED provides that a contract modification may include a change in the nature or amount of the goods or services promised to the customer, a change in the method or timing of performance under the contract by any party or a change in the previously agreed pricing in the contract. In their basis for conclusions, the Boards explain that modifications to contracts should follow the same principles as those applied to the segmentation or combination of contracts. Under the proposed model, if the contract modification is tied to the original contract through price interdependency, the modified terms are accounted for as part of the original contract. Alternatively, if the modifications to the contract provides for the provision of goods or services priced independently, the additional goods or services are viewed as performance obligations in a new contract accounted for independently. The effect on the amount and timing of revenue recognition at the date of the contract modification differs based on whether or not the modification is accounted for together with the existing contract. A modification accounted for together with the existing contract requires a reallocation of the consideration to the identified performance obligations. To the extent the reallocation of transaction consideration affects satisfied performance obligations, the entity would recognize the cumulative effect of the contract modification (positive or negative) in the period the modification occurs. In effect, the cumulative accounting for a contract modification would result in revenue recognized as though the modified terms had been included in the existing contract. Conversely, if the entity concludes that the contract modification results in a new contract, the entity would apply the proposed model separately to the new performance obligations included in the contract modification. Financial reporting developments The road to convergence: the revenue recognition proposal 11

18 Chapter 2: Identify the contract with the customer Example 3 contract modification The Boards provide the following example in Paragraph IG3 of the ED to demonstrate the accounting for contract modifications: Scenario 1 services that do not have interdependent prices An entity enters into a three-year services contract. The payment terms are $100,000 payable annually in advance. The standalone selling price of the services at contract inception is $100,000 per year. At the beginning of the third year (after the customer had paid the $100,000 for that year), the entity agrees to reduce the price for the third year of services to $80,000. In addition, the customer agrees to pay an additional $220,000 for an extension of the contract for 3 years. The standalone selling price of the services at the beginning of the third year is $80,000 per year. To account for the contract modification, the entity must evaluate whether the price of the services provided before the contract modification and the price of the services provided after the contract modification are interdependent. The services provided during the first 2 years are priced at the standalone selling price of $100,000 per year. Moreover, the services provided during the subsequent 4 years are priced at the standalone selling price of $80,000 per year. Hence, the entity concludes that the price of the contract modification and the price of the original contract are not interdependent. Although the services are provided continuously, the price of the services in the first 2 years and the price of the subsequent services are negotiated at different times and in different market conditions (as evidenced by the significant change in the standalone selling price of the service). Consequently, the entity accounts for the contract modification separately from the original contract. $20,000 of the $100,000 payment received at the beginning of the third year (before the modification) is a prepayment of services to be provided in the future years. Therefore, the entity recognizes revenue of $100,000 per year for the 2 years of services provided under the original contract and $80,000 per year for services provided during the subsequent 4 years of services under the new contract. 12 Financial reporting developments The road to convergence: the revenue recognition proposal

19 Chapter 2: Identify the contract with the customer Scenario 2 services that have interdependent prices The facts are the same as Scenario 1 except that at the beginning of the third year the customer agrees to pay an additional $180,000 for an extension of the contract for 3 years. The services provided during the first 2 years are priced at their standalone selling price of $100,000 per year. However, the services provided during the subsequent 4 years are priced at a $40,000 discount [($80,000 standalone selling price per year 4 years) ($100,000 prepayment + $180,000 remaining payment)] and, therefore, their price is dependent on the price of the services in the original contract. Hence, the entity concludes that the price of the contract modification and the price of the original contract are interdependent. Consequently, the entity accounts for the contract modification together with the original contract. At the date of modification, the entity recognizes the cumulative effect of the contract modification as a reduction to revenue in the amount of $40,000 [($480,000 total consideration 6 years of total services 2 years services provided) $200,000 revenue recognized to date]. The entity recognizes revenue of $100,000 per year for the first 2 years $40,000 in the third year, and $80,000 per year in the fourth, fifth, and sixth years. In certain industries, parties frequently modify contractual arrangements before completion. Entities will have to determine whether such change orders are separate contracts or modifications of the original contract under the proposed model. This assessment will require the use of judgment as it will frequently be difficult to determine whether the pricing of the change order is interdependent upon the pricing in the original contract. The requirement to determine whether to treat a change order as a separate contract or a modification to an existing contract is relatively consistent with current US GAAP. However, the application of the requirement may change as a result of the proposed guidance, resulting in different conclusions in some cases. Financial reporting developments The road to convergence: the revenue recognition proposal 13

20 Chapter 3: the separate performance obligations in the contract Chapter 3: Identify the separate performance obligations in the contract A performance obligation is defined in the ED as an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. The proposed guidance requires an entity to identify all promised goods and services and determine whether to account for each good or service as a separate performance obligation. Paragraph 21 in the ED provides examples of goods or services that may give rise to a performance obligation. Excerpt from the ED 21. Contracts with customers oblige an entity to provide goods or services in exchange for consideration. Goods or services include the following: (a) goods produced by an entity for sale (for example, inventory of a manufacturer); (b) goods purchased by an entity for resale (for example, merchandise of a retailer); (c) arranging for another party to transfer goods or services (for example, acting as an agent of another party); (d) standing ready to provide goods or services (for example, when- and if-available software products); (e) constructing or developing an asset on behalf of a customer; (f) granting licenses, rights to use and options; and (g) performing a contractually agreed task (or tasks). Properly identifying the individual performance obligations within a contract is a critical component of the proposed revenue model as revenue allocated to each performance obligation is recognized as each performance obligation is satisfied. Additionally, as discussed further in Section 7.1, whether or not an arrangement contains onerous components is determined at the performance obligation level. The concept of identifying separate performance obligations is similar to identifying a deliverable or element under current US GAAP. As a result, we believe that in many cases entities that transact in multiple-element arrangements will identify a similar number of goods and services under the proposed model as they do under current US GAAP. 14 Financial reporting developments The road to convergence: the revenue recognition proposal

21 Chapter 3: Identify the separate performance obligations in the contract However, the new guidance likely will have a significant effect on entities that do not currently account for revenue transactions under the guidance for multiple-element arrangements. For example, the guidance in ASC for certain production-type and construction-type contracts does not require an entity to identify the individual goods and services within an arrangement. Under the proposed model, in a contract to construct an office building, the construction firm may consider the (a) customized design, (b) engineering and (c) construction to each represent separate performance obligations. Alternatively, the construction firm may determine that the activities included within those services, such as the erection the physical building, the electrical wiring within the building, and the heating, cooling and ventilation within the building, represent separate performance obligations. Since the model requires the evaluation of identified goods and services to determine whether they are separate performance obligations, and the satisfaction of performance obligations drives revenue recognition, the identification of goods and services is an important first step. While the ED provides illustrative guidance on this topic, it remains unclear exactly how this guidance applies to transactions that contain numerous steps to complete. We expect that the guidance in this area, and the interpretation of this guidance, will continue to evolve as the Boards move toward a final standard. 3.1 Distinct goods and services In order to identify the performance obligations within an arrangement, an entity determines which promised goods and services are distinct from one another. That is, distinct goods and services are considered individual performance obligations. Contracts to provide goods and services to customers will often contain multiple performance obligations. The ED provides criteria for determining whether a good or service is distinct in Paragraph 23. Excerpt from the ED 23. A good or service, or a bundle of goods or services, is distinct if either: (a) The entity, or another entity, sells an identical or similar good or service separately Or (b) The entity could sell the good or service separately because the good or service meets both of the following conditions: i. It has a distinct function a good or service has a distinct function if it has utility either on its own or together with other goods or services that the customer has acquired from the entity or are sold separately by the entity or by another entity ii. It has a distinct profit margin a good or service has a distinct profit margin if it is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service Financial reporting developments The road to convergence: the revenue recognition proposal 15

22 Chapter 3: Identify the separate performance obligations in the contract The determination of whether a good or service is distinct may in many cases be subjective and require the application of considerable professional judgment. The best evidence that a good or service is distinct is when the good or service is sold separately by the entity or any other market participant. Multiple-element transactions Consistent with the determination of standalone value under current US GAAP, the determination of whether or not a good or service is a distinct performance obligation may require the use of judgment. When the good or service is sold separately, the conclusion is straightforward. However, in the absence of standalone sales, the entity may still determine that the good or service is distinct by showing that the good or service, while not currently sold separately, could be sold separately. The Boards provide two criteria that must be met to support that assertion 1) the good or service has a distinct function and 2) the good or service has a distinct profit margin. Requiring that a good or service has a distinct function is consistent with the guidance in ASC , which requires that a deliverable have value to the customer on a standalone basis. That is, for a good or service to have a distinct function (i.e., the good or service has utility on its own or when combined with another asset), the good or service is essentially required to be an asset that generates some economic benefit (i.e., value) to the customer. The criterion in the proposed guidance that the good or service have a distinct profit margin, however, is not one that exists currently in ASC While not included in ASC , this concept is similar to the guidance on construction-type contracts in ASC that requires an element to have a different rate of profitability to be accounted for separate from other elements. When a standalone selling price is known, the profit margin is readily determinable in most cases. However, demonstrating a distinct profit margin when a selling price is not observable (because the good or service is not sold separately) is difficult. The Boards concluded that in the absence of an observable selling price, the entity would have sufficient basis for estimating the selling price only when the good or service is subject to distinct risks and the entity can identify the distinguishable resources needed to provide the good or service. This represents a significant change in the accounting for multiple-element arrangements today. 16 Financial reporting developments The road to convergence: the revenue recognition proposal