February 1, 2018 Financial Reporting Center Revenue Recognition Working Draft: Aerospace and Defense Revenue Recognition Implementation Issue Issue #1-5: Transfer of Control on Non-US Federal Government Contracts Issue #1-5 was finalized in June 2016 and is included in the AICPA Audit and Accounting Guide: Revenue Recognition, in paragraphs 3.5.01 3.5.21 of the Aerospace & Defense Entities Chapter. Further clarification was requested on whether a contract priced at a loss could qualify for over time recognition in accordance with FASB ASC 606-10-25-27(c). The AICPA is seeking feedback on the revised wording shown as marked changes in paragraphs 3.5.19 3.5.23 by April 2, 2018. Wording to be Included in the Revenue Recognition Guide: Step 5: Recognize Revenue When (or as) the Entity Satisfied a Performance Obligation Satisfaction of Performance Obligations Transfer of Control on Non-U.S. Federal Government Contracts This Accounting Implementation Issue Is Relevant to Step 5: "Recognize Revenue When (or as) the Entity Satisfied a Performance Obligation," of FASB ASC 606. 3.5.01 Commercial aerospace and defense contracts encompass many different types of transactions: manufacturing of standardized products; rendering of services, such as maintenance or training, or construction-type contracts to design, develop, manufacture, or modify complex aerospace or electronic equipment to a buyer's specification. 3.5.02 FASB ASC 606-10-25-23 states the following: An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. 3.5.03 FASB ASC 606 explains that revenue should be recognized when (or as) an entity satisfies a performance obligation by transferring control of a good or service to a customer. Control of a good or service can transfer over time or at a point in time. If a performance obligation is satisfied over time,
revenue allocated to that performance obligation will be recognized over time. FASB ASC 606-10-25-30 explains that if a performance obligation does not meet the criteria to be satisfied over time, it is deemed to be satisfied at a point in time. 3.5.04 Aerospace and defense companies should determine whether a performance obligation meets the criteria to be satisfied over time or if satisfaction occurs at a point in time. As noted in FASB ASC 606-10-25-24, this assessment is performed at contract inception and may only be revised during the contract in the event of certain contract modifications, for instance, change to rights to payment, change to contract scope that affects the alternative use of the assets being produced, and so on. Performance Obligations Satisfied Over Time 3.5.05 FASB ASC 606-10-25-27 states that An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if one of the following criteria is met: a. The customer simultaneously receives and consumes the benefits provided by the entity s performance as the entity performs; b. The entity s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced; c. 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. 3.5.06 Aerospace and defense entities will need to examine at contract inception the facts and circumstances to determine whether performance obligations in aerospace and defense contracts meet any of the criteria in FASB ASC 606-10-25-27. Simultaneous Receipt and Consumption of the Benefits of the Entity s Performance 3.5.07 Assessing the criterion in FASB ASC 606-10-25-27a can be straightforward as explained in FASB ASC 606-10-55-5 for routine or recurring services or situations in which the entity s performance is immediately consumed by the customer. FASB ASC 606-10-55-6 also notes that the criterion in FASB ASC 606-10-25-27a could be met if an entity determines that another entity would not need to substantially reperform the work that the entity has completed to date, if that other entity were to fulfill the remaining performance obligation to the customer. FinREC believes that this criterion is likely to be relevant for certain commercial aerospace and defense service performance obligations, such as maintenance, training or transportation services. Customer Controls the Asset As It Is Created or Enhanced 3.5.08 The criterion in FASB ASC 606-10-25-27b addresses situations in which the customer controls any work in process, either tangible or intangible, as it is created or enhanced. 3.5.09 FASB ASC 606-10-25-25 states the following: Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by: a. Using the asset to produce goods or provide services (including public services) b. Using the asset to enhance the value of other assets
c. Using the asset to settle liabilities or reduce expenses d. Selling or exchanging the asset e. Pledging the asset to secure a loan f. Holding the asset. 3.5.10 Judgment will be required to determine if control of the asset transfers to the customer while the asset is being created or enhanced. Aerospace and defense contracts in which the entity performs on or enhances the customer s asset may transfer control to the customer over time. Management should analyze the contract s terms and conditions and other facts and circumstances to determine, for example, if the entity has a right to payment for its performance to date, if the legal title, physical possession, or risks and rewards of ownership related to the asset pass to the customer as the asset is created or enhanced, if the customer accepts the asset as it is created or enhanced, or if the customer controls the underlying land or asset that the entity is enhancing. Entity s Performance Does Not Create an Asset With an Alternative Use 3.5.11 The criterion in FASB ASC 606-10-25-27c includes both the assessment of whether the entity s performance does not create an asset with an alternative use to the entity and whether the entity has an enforceable right of payment for performance completed to date. 3.5.12 As discussed in BC134 of FASB ASU No. 2014-09, when the asset has an alternative use to the entity, the customer does not control the asset as it is being created. This is expected to be the case in standard inventory-type items for which the entity has the discretion to substitute items or units across different contracts with customers. 3.5.13 Some assets, such as commercial aircrafts or engines and components and parts to that equipment, may be less customized when manufactured under non-u.s. government contracts than assets produced under U.S. government contracts. However, BC137 of FASB ASU No. 2014-09 explains that the level of customization is not the only criterion to determine whether the asset has an alternative use. As stated in FASB ASC 606-10-25-28, "an asset created by an entity s performance does not have an alternative use to an entity if the entity is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use. An example would be if the entity cannot sell the asset to another customer without significant rework. 3.5.14 As discussed in FASB ASC 606-10-55-8, assessment of the "no alternative use" criteria should be made assuming the contract with its customer is not terminated. 3.5.15 In accordance with FASB ASC 606-10-25-28, an entity should also consider at contract inception the characteristics of the asset in its complete form because it will ultimately transfer to the customer. BC136 of FASB ASU No. 2014-09 provides the example of an asset that has the same basic design as many other assets that the entity sells to other customers. However, customization is substantial and would prevent the entity from redirecting the asset in its complete state to another customer without significant rework. Although the asset may likely have an alternative use to the entity in the early stage of its manufacturing process, (that is before customization activities start), the entity should conclude from inception that the asset has no alternative use. 3.5.16 FASB ASC 606-10-55-10 states that "a practical limitation on an entity s ability to direct an asset for another use exists if an entity would incur significant economic losses to direct the asset for another use." FinREC believes that situations that may create practical limitations include, but are not limited to, significant level of customization and rework necessary to redirect the asset to another use, resale at a significant loss, limited production slots that may limit the capability of the entity to redirect the asset while still meeting its obligations (such as contractual deadlines) under the contract with the customer, and the asset is located in a remote location where significant transportation costs would be incurred to redirect the asset for another use.
3.5.17 As stated in FASB ASC 606-10-55-9, "a contractual restriction on an entity s ability to direct an asset for another use must be substantive for the asset not to have an alternative use to the entity." For instance, if a contract prevents the entity from substituting the asset for another asset, but, in practice, the entity manufactures other similar assets and those assets are interchangeable, have no serial number or other way of being individually identified, and the entity would not incur significant costs by substituting the asset, the contractual clause would likely be assessed as non-substantive. When assessing whether a contractual restriction confers a "non-alternative use" to the asset, the entity should consider whether the contractual restriction represents only a protective right to the customer and whether the customer could enforce its rights to the promised asset. As discussed in BC138 of FASB ASU No. 2014-09, a protective right typically results in the entity having the practical ability to physically substitute or redirect the asset without the customer being aware of or objecting to the change. Enforceable Right to Payment for Performance Completed to Date 3.5.18 When the asset created has no alternative use to the entity, the entity still needs to demonstrate it has an "enforceable right to payment for performance completed to date" in order to satisfy the criteria in FASB ASC 606-10-25-27c and meet the requirements to conclude that satisfaction of a performance obligation and revenue should be recognized over time. Both of the criteria in FASB ASC 606-10-25-27c need to be met; a right to payment for performance to date alone does not, in itself, demonstrate that control has transferred. 3.5.19 As per FASB ASC 606-10-55-11, the entity needs to demonstrate that if the contract was to be terminated early for reasons other than the entity s failure to perform as promised, it would be entitled to an amount that compensates the entity for its performance to date. An amount that would compensate an entity for performance completed to date would be an amount that approximates the selling price of the goods or services transferred to date rather than compensation for only the entity s potential loss of profit if the contract were to be terminated. For example, an entity could evidence an enforceable right to payment based on the ability to recover the costs incurred to date in satisfying the performance obligation plus a reasonable profit margin. In this case, the entity needs to demonstrate that the margin recovered for the goods or services transferred to date represents a reasonable margin. Significant judgment will be required, particularly in circumstances in which the entity is entitled to a margin that is proportionally lower than the one it would expect to obtain if the contract is completed. 3.5.20 Although it would generally be expected that entities would price their contracts to obtain a reasonable profit, there are circumstances in which an entity would be willing to sell a good or service at a loss. For example, an entity might be willing to incur a loss on a sale if it has a strong expectation of obtaining a profit on future orders from that customer, even though such orders are not contractually guaranteed. The objective of the right to payment criterion in FASB ASC 606-10-25-27(c) as described in BC142 of FASB ASU 2014-09 is to assess whether the customer is obligated to pay for performance to date. Compensation for the entity s performance for a contract negotiated at a loss, is an amount that is less than the entity s costs. FinREC believes the principle for assessing the enforceable right to payment for performance completed to date as described in FASB ASC 606-10- 25-27(c) is based on whether the entity has a right to an amount that approximates the selling price; therefore, an entity does not need to have a profit in order to meet this criterion. Accordingly, FinREC believes certain contracts priced at a loss may qualify for over time recognition under FASB ASC 606-10-25-27(c) if the enforceable right to payment for performance completed to date is based on the selling price which may not contain a profit. This section does not address or change the requirements for when an entity would be required to record a loss accrual related to a contract. 3.5.210Under the termination for convenience clause in most U.S. federal government contracts, the government typically has a right to the goods or work in progress produced, and the contractor is entitled to payment for its performance to date if the contract is terminated early for reasons other than default. Non-U.S. federal government contracts may operate under different terms.
3.5.221As described in FASB ASC 606-10-55-14, management should analyze the terms and conditions of the contract as well as any laws that govern the transaction in order to determine if the entity s performance gives rise to an enforceable right to payment for performance completed to date at any given time. Legal precedents as well as customary business practices should also be considered in case they alter the capacity of the entity to enforce their right to payment. 3.5.23 The following example is meant to be illustrative, of when a contract negotiated at a loss at inception meets the criteria for satisfaction of performance obligations over time. The actual determination of whether the performance obligation is satisfied over time or at a point in times should be based on facts and circumstances of an entity s specific situation. Example 1 A Country (the customer) puts out a request for bids for the design of a highly customized defense system. Country expects to award subsequent contracts for tens of thousands of systems over the next ten years from whoever wins the design contract. There are four contractors bidding for this contract. Contractor A is aware of the competition and knows that in order to win the design contract they must bid it at a loss. Contractor A is willing to bid the design contract at a loss due to the significant value in expected orders over the next ten years. Contractor A wins the contract with a value of $100 and estimated costs to complete of $130. The contract is noncancellable; however, the contract terms stipulate that if Country attempts to terminate the contract, Contractor A would be entitled to payment for work done to date. The payment amount would be equal to a proportional amount of the price of the contract based upon the performance of work done to date. For example, if the Contract Value was $100 and the estimated total cost was $130, at the termination date, if Contractor A was 50% complete or had incurred $65 of costs, it would be entitled to a $50 payment from Country. For the purposes of this example, Contractor A has determined the contract contains a single performance obligation and performance of work is done ratably over the contract period. Contractor A has also determined that its performance does not create an asset with an alternative use due to the highly customized design of the defense system. Thus, the conclusion regarding whether Contractor A has an enforceable right to payment will determine whether revenue should be recognized over time or at a point in time. This example does not address or change the requirements as to whether Contractor A would be required to record a loss accrual related to the contract. In this example, Contractor A has an enforceable right to payment for performance completed to date in accordance with paragraph FABS ASC 606-10-25-27(c) because it is entitled to receive a proportionate amount of the contract price in the event Country terminates the agreement. FASB ASC 606-10-55-11 refers to an amount that approximates the selling price of the goods or services transferred to date and cites cost plus a reasonable profit margin as an example of an amount that would represent selling price for performance completed to date. Compensation for the entity s performance in this example, as negotiated by the parties, is an amount that is less than the entity s costs. Therefore, in this example, the analysis is focused on whether the entity has a right to a proportionate amount of the selling price (reflecting performance to date) rather than solely based on whether such amount is greater than or less than the entity s costs to fulfill the contract. Comments on paragraphs 3.5.19 3.5.23 should be received by April 2, 2018, and sent by electronic mail to Kim Kushmerick at kim.kushmerick@aicpa-cima.com, or you can send them by mail to Kim Kushmerick, Accounting Standards, AICPA, 1211 Avenue of the Americas, NY 10036.
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