the new revenue recognition standard: a first look … · the new revenue recognition standard: a...

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THE NEW REVENUE RECOGNITION STANDARD: A FIRST LOOK AT INDUSTRY IMPACT

ACCOUNTING POLICY& PRACTICE REPORT

SPECIAL REPORT

THE NEW REVENUERECOGNITION STANDARD: A

FIRST LOOK AT INDUSTRYIMPACT

By Lisa M. StarczewskiBuchanan Ingersoll & Rooney PC

Special Consultant to Bloomberg BNAWith Contributions By

Arent Fox LLPChess Consulting LLC

EisnerAmper LLP

� 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.

Accounting Policy & PracticeSpecial Report

July 18, 2014Volume 10, Number 3

ACCOUNTING POLICY & PRACTICE SPECIAL REPORT

Darren McKewen, President, Tax and Specialty

Lisa Fitzpatrick, Vice President and Group Publisher, Tax and Accounting

George R. Farrah, Executive Editor, Tax and Accounting

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Laurie Sagherian, Accounting Editor

Laura Tieger-Salisbury, Copy Editor

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2 � 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.

TABLE OF CONTENTS

INTRODUCTION—SAYING GOODBYE TO INDUSTRY-SPECIFIC GUIDANCE................................................................... 5

TELECOMMUNICATIONS, CABLE & SATELLITE TELEVI-SION ................................................................................................ 9

TECHNOLOGY (SOFTWARE/IP) .................................................. 15

MEDIA & ENTERTAINMENT .......................................................... 21

AEROSPACE & DEFENSE ............................................................. 27

LIFE SCIENCES ............................................................................... 37

� 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. 3

Introduction

SAYING GOODBYE TO INDUSTRY-SPECIFIC GUIDANCE

By Lisa StarczewskiBuchanan Ingersoll & Rooney PCSpecial Consultant to Bloomberg BNA

Lisa Starczewski is a Senior Tax Counsel at Buchanan, Ingersoll & Rooney andserves as a Special Consultant and Author for Bloomberg BNA’s tax and ac-counting products. She is a subject matter expert in a number of tax and ac-counting areas and teaches and writes extensively. Her tax practice focuses pri-marily on corporate and partnership tax planning. She has written several Portfo-lios for Bloomberg BNA, including a series on revenue recognition.

On May 28, 2014, the Financial Accounting Standards Board and the Interna-tional Accounting Standards Board (the ‘‘Boards’’) jointly issued a new financialaccounting revenue standard that significantly changes the approach to revenuerecognition. The Boards have replaced industry-specific guidance with a single,comprehensive model based on foundational principles and objectives. For a de-tailed analysis of the new rules, see (10 APPS 5, 6/6/14).

Almost every company applying U.S. generally accepted accounting principles(GAAP) or international financial reporting standards (IFRS) will be affected insome way by these changes because every company will have to apply this newapproach and will be subject to expanded disclosure requirements. However, thenew rules will impact certain industries more significantly than others, particu-larly those that currently rely on industry-specific guidance, which will be super-seded by the new standard, once it is effective.

This Report focuses on the potential impact of these changes on several indus-tries, including:

s Telecommunications, Cable & Satellite Television

s Technology (Software/IP)

s Media & Entertainment

INTRODUCTION


s Aerospace & Defense

s Life Sciences

The question of what industries and what types of transactions will be most sig-nificantly affected by the new revenue rules is an open one—no one knows, de-finitively, how extensive the impact will be. Moreover, the nature of the impactmay vary depending on the transaction or industry. In some cases, there may bea delay in revenue recognition. However, in many cases, revenue recognitionwill be accelerated.

The Boards have continually stressed that the new standard is contract-based, nottransaction- or industry-based. The Boards did not provide industry-specificguidance in the Implementation Guidance. Although the Implementation Guid-ance includes 63 examples, many of which contain several different scenarios,the introduction to the Illustrations Subsection makes it clear that the examplesare not intended to create industry-specific or transaction-specific guidance andthat, in all cases, an entity must evaluate its particular facts and circumstances toproperly apply the standard. Although it is always necessary to look at particularfacts and circumstances when analyzing examples, the FASB went out of its wayto emphasize this in the final revenue standard.

The American Institute of CPAs (AICPA) recently formed 16 industry-specifictask forces to aid in the development of a new AICPA Accounting Guide onRevenue Recognition (10 APPR 563, 6/20/14). The industries include:

s Aerospace & Defense

s Airlines

s Broker-Dealers

s Construction Contractors

s Depository Institutions

s Gaming

s Health Care

s Hospitality

s Insurance

s Investment Companies

s Not-for-Profit

s Oil and Gas

s Power & Utility

s Software

s Telecommunications

s Timeshare



Each Task Force will identify implementation issues, which will be reviewed bythe AICPA Financial Reporting Executive Committee and will then be posted forinformal comment. The FASB has expressed concern over the creation of anyindustry-specific revenue guides and has specifically indicated that it hopes thatthe AICPA will create general revenue guides that are applicable to all transac-tions and industries.

As time passes and there is increased opportunity for analysis and discussion ofthe new standard, it is anticipated that industry groups will identify implementa-tion issues and accounting firms (particularly the Big 4) will begin to take posi-tions with respect to those issues. The extent and complexity of the implementa-tion issues remains to be seen.

What is clear, however, is that the FASB and IASB are adamantly opposed tothe creation of industry-specific revenue rules. Thus, regardless of the issue orthe industry, the analysis must begin and end with the five-step process and theother foundational guidance in the new revenue standard. Positions taken withrespect to an implementation issue in a particular industry must be based on areasonable application of the new revenue rules to a particular set of facts andcircumstances and not on an industry-specific carve-out or exception. It will betempting to stretch the language of the new standard to allow for industry-specific interpretations. However, this is not the desired result.

‘‘[Companies that currently use industry-specific guidance] want to take the

guidance and look at the specific words and see what, exactly, has changed

. . . and then stretch the words to minimize change . . . the same words

can be stretched very far depending upon the context—but the Boards want

the focus to keep coming back to the contract and the substance of the

contract and not to the nature of the transaction in a given industry.’’

FASB STAFF MEMBER,FASB CPE PROVIDER FORUM (JAN. 30, 2014)

In an effort to be proactive and limit diversity in practice once the standard iseffective, the Boards created a Revenue Recognition Transition Resource Groupto identify and respond to implementation issues (10 APPR 527, 6/6/14). TheFASB does not want accounting firms to take diverse positions and it wants tobe involved in the positions that are being taken.

Now that the final revenue standard has been issued, companies are actively pre-paring for its application. In fact, many larger companies have had implementa-tion teams in place for a long time monitoring the standard’s evolution and as-sessing its impact. As companies continue to digest and apply the new guidance,the specific impacts on various industries and transactions will become clearer.

INTRODUCTION


There is no question, however, that there will be significant change in revenuerecognition patterns for many companies and, in all cases, companies will beapplying a new set of principles to determine whether and to what extent rev-enue is recognized.



Telecommunications

TELECOMMUNICATIONS, CABLE & SATELLITE TELEVISION

Arent Fox LLPBy Alan G. FishelBy Adam D. BowserBy Radhika Bhat

Arent Fox LLP, founded in 1942, is internationally recognized in core practiceareas where business and government intersect. With more than 350 lawyers, thefirm provides strategic legal counsel and multidisciplinary solutions to clientsthat range from Fortune 500 corporations to trade associations. The firm has of-fices in Los Angeles, New York, San Francisco, and Washington, D.C.

Identifying Separate Performance Obligations

FASB and IASB have chosen not to include industry-specific special rules intheir new revenue recognition standard regarding what are commonly called‘‘bundled arrangements.’’ Bundled arrangements are transactions in which a re-porting entity promises to transfer services to a customer together with a distinctgood that relates to its provision of those services. Perhaps no other industry isas substantively affected by this aspect of the revenue recognition rule than thetelecommunications industry. To a lesser extent, cable and satellite service pro-viders are similarly affected.

The most common example of a bundled arrangement in the telecommunicationsindustry is the provision of a free or significantly discounted cellular phone (orhandset) with the purchase of cellular service. A similar equipment discount isoften provided in the cable and satellite service industries for bundled servicearrangements that include equipment such as routers, set top boxes, digital videorecorders (DVRs), dish antennae or receivers, and other related equipment that asubscriber uses in conjunction with the underlying service.

Current U.S. GAAP revenue recognition rules allow ample room for industry-specific accounting principles that take into consideration different scenarios forrecognizing revenue. For instance, the amount of consideration that a telecom-

TELECOMMUNICATIONS


munications company allocates to the handset has historically been limited to theamount that is not contingent on the satisfaction of the unsatisfied obligation (theprovision of services). This means that the amount of revenue that the telecom-munications company recognizes on the transfer of the phone is limited to theamount of consideration it receives from the customer at the inception of thecontract.

The new rules, however, require companies to determine the number of perfor-mance obligations in a single contract. Companies must then allocate the trans-action price on a relative stand-alone selling price basis to the goods and ser-vices that underlie each performance obligation. Under the new rules, the trans-fer of the handset or other equipment will be recognized as a performanceobligation, and the reporting entity will be required to allocate consideration tothe handset using the relative stand-alone selling price method. Thus, a telecom-munications company will allocate a more significant portion of the transactionprice to the handset in a direct sale. Handset revenue will increase and servicerevenue will decrease.

A telecommunications company will allocate a more significant portion of the

transaction price to the handset in a direct sale. Handset revenue will

increase and service revenue will decrease.

This change in accounting will likely affect key metrics in the telecommunica-tions industry (e.g., average revenue per user). Importantly, accelerating revenuein these circumstances is not necessarily consistent with the underlying econom-ics of the transaction. For instance, most entities in the telecommunications in-dustry see the cost or subsidy related to a new handset or router as part of thecost required to obtain a new subscriber to the underlying service, as opposed toa distinct transaction with its own performance obligations.

In addition, under the new rules, the accounting for sales through direct channelsversus indirect channels will be different. This could arguably make the informa-tion in telecommunications companies’ financial statements less useful and moreconfusing. As discussed below in the illustrations, despite the economics fromthe customer’s perspective being nearly identical, the amounts recognized forequipment revenue and service revenue will likely vary for telecommunicationscompanies based upon the sales channel they use to deliver equipment and/orservice.

The telecommunications and satellite television industries rallied for an excep-tion to the requirement that they allocate consideration for service-related equip-ment equal to the equipment’s stand-alone selling price, but the Boards deniedtheir request. In the interest of consistency and in keeping with the Boards’ de-sire to eliminate industry specific guidance, the Boards opted not to provide any



specific exception from application of the allocation rules to bundled arrange-ments. The Boards pointed out that if certain conditions are met, a reporting en-tity is allowed to apply the new revenue requirements to a portfolio of contracts,which they believe may make application of this guidance to bundled arrange-ments a little simpler. In reality, however, the types of contracts offered by mosttelecommunications, cable, and satellite service providers are so diverse that con-sistently and reliably aggregating contracts into portfolios may not be feasible.

Under the new rules, the accounting for sales through direct channels versus

indirect channels will be different. This could arguably make the information

in telecommunications companies’ financial statements less useful and

more confusing.

In any case, implementation of these revenue recognition changes will likely becostly and complicated for companies in these industries. In addition, in an effortto supply users of their financial statements with reliable, consistent information,many of these companies may continue to prepare and present data under currentU.S. GAAP even after the effective date of the new rules, along with data pre-pared pursuant to the new guidance.

Illustration A: Direct Sales Channel

Where Telecommunications Company (TC) sells directly to customers, it typi-cally enters into a contract with a customer pursuant to which TC agrees to sup-ply the customer with a handset and two years of cellular service. Upon contractinception, the customer pays $100 for the handset and agrees to pay $30 amonth for 24 months for the cellular service. The stand-alone selling price forthe handset, without a service contract, is $300. The stand-alone selling price ofone month of cellular service is $30. Under current U.S. GAAP, TC would rec-ognize $100 of revenue upon transfer of the handset to the customer and recog-nize the remaining $720 of revenue over the two-year term of the contract. Inthese types of transactions, under current rules, TC would recognize an upfrontloss equal to the difference between the consideration received from the cus-tomer (in this case, $100) and the inventory cost derecognized (in this case,$300). TC recognizes this loss in exchange for the customer’s two-year commit-ment to purchase cell service.

Under the new rules, TC will allocate $241 of the total transaction price to thetransfer of the handset [($300, stand-alone selling price of the phone)/($1020,total stand-alone selling prices of all promised goods or services)*($820, totaltransaction price)] and $579 to the provision of services over the term of thecontract.

TELECOMMUNICATIONS


Illustration B: Indirect Sales Channel

Where TC also sells its services through a third-party vendor who acts as itsagents, the third-party vendor acquires the handsets as inventory and sells themdirectly to the customer. TC then pays the third-party vendor some amount ofconsideration to act as its agent in the sale of the cellular service to the cus-tomer. Under the current rules, the consideration is generally recognized as acombination of a sales commission and a subsidy on the handsets. From thestandpoint of TC, the commission it pays to the third-party vendor is similar tothe upfront loss it sustains in a direct sale (as in the example above).

However, under the new rules, TC should recognize the incremental costs ofobtaining a contract (e.g., sales commissions) as an asset and amortize thosecosts on a systematic basis over the period of service if TC expects to recoverthem. Pursuant to the practical expedient, TC would be allowed to recognizethese costs as an expense when incurred only if the amortization period of theasset that the entity otherwise would have recognized is one year or less. Thus,if the period of service is more than one year, TC will capitalize the commissionin an indirect sale at contract inception and amortize it over the term of the con-tract. In addition, in an indirect sale, the only performance obligation that existsbetween TC and the customer is the obligation to provide cellular service. There-fore, the entire monthly amount paid by the customer for that service is allocatedto provision of the service ($720 in the example above). This will potentiallyresult in service revenue that will be higher for indirect sales as compared todirect sales.

Options to Renew

Contracts for service in the telecommunications, cable, and satellite service in-dustries frequently contain options to renew without additional up-front fees(e.g., activation or installation fees for equipment or service). Under the newrules, companies must determine whether an option to renew constitutes a sepa-rate performance obligation within a contract. If an option is a separate perfor-mance obligation, the company must then allocate a portion of the transactionprice to the renewal option itself, and the revenue would only be recognizedwhen the renewal option was exercised or forfeited.

Whether an option to renew is considered a separate performance obligation de-pends on whether the option grants the customer a material right the customerwould not have had without entering into the contract. This determination willlikely be fact and circumstance specific, taking into account the length of thecontract, the monetary amounts of the activation or installation fees in compari-son to the fees for all services under the contract, and other such factors.

Contract Modifications

The new rules also have implications for modified or amended contracts—a fre-quent occurrence in the telecommunications, cable, and satellite service indus-tries. A contract modification under the new revenue standard is defined as an



‘‘approved’’ change in scope or price to the existing contract. A contract modifi-cation is ‘‘approved’’ if it in fact creates or changes the enforceable rights andobligations of the parties under an existing contract, regardless of whether themodification has been formally approved. Moreover, an approval can be written,oral or implied by customary business practices.

In the telecommunications, cable, and satellite service industries, it is not un-common for subscribers to request changes or additions to the bundle of servicesthey receive under an existing contract. Whether it is to add an additional line ornumber to their cellular service account, or to upgrade/downgrade to a differentservice package, under the new revenue recognition rules these contract modifi-cations can create new performance obligations and rights for the parties to theexisting contract. Once the company and customer have agreed to a change inscope or price, the company will apply the contract modification guidance underthe new rules to the modified contract as soon as it has an expectation that theprice will be approved.

Under the new revenue standard, the test for determining whether a reportingentity will be required to account for a contract modification as a new and sepa-rate contract is whether the modification results in both of the following: (1)promised goods or services that are ‘‘distinct’’ (that is, the modification results inthe addition of a separate performance obligation); and (2) an entity’s right toreceive an amount of consideration that reflects the entity’s standalone sellingprice of the promised good(s) or service(s) and any appropriate adjustments tothat price to reflect the circumstances of the particular contract.

Illustration C:

TC enters into a two-year service contract with customer. Six months into thecontract, customer requests to add a new line (an additional cellular telephonenumber) to the account. This additional service is a distinct service that will re-sult in TC’s right to receive additional consideration—either in the form ofhigher monthly fees or an extended service contract. Under the new revenue rec-ognition standard, this modification, once approved, will likely trigger new per-formance rights and obligations by the parties and should be treated as a separatecontract that does not impact the accounting for the existing contract.

If two months later the same customer requests an upgrade to the data packagethat is associated with the account, this modification will likely also result innew performance rights and obligations that are distinct and entitle TC to addi-tional consideration. As such, the new revenue standard would again require thatthe modification be treated as a new and separate contract.

TELECOMMUNICATIONS


Technology (Software/IP)

TECHNOLOGY (SOFTWARE/IP)

EisnerAmper LLP

By Marc FogartyBy Karen Schwartz

EisnerAmper LLP is a leading full-service advisory and accounting firm, and isamong the largest in the United States. We provide audit, accounting, and taxservices, as well as corporate finance, internal audit and risk management, litiga-tion services, consulting, private business services, employee benefit plan audits,forensic accounting, and other professional advisory services to a broad range ofclients across many industries. We work with high net worth individuals, familyoffices, closely held businesses, start-ups, middle market and Fortune 500 com-panies. EisnerAmper is PCAOB-registered and provides services to more than150 public companies and over 1,300 financial services entities and portfoliocompanies. With offices in New York, New Jersey, Philadelphia, California andthe Cayman Islands, and as an independent member of PKF International, Eis-nerAmper serves clients worldwide.

The new revenue recognition guidance will likely have a profound impact on theTechnology Industry. The issues noted below are those areas where the Technol-ogy Industry is expected to be impacted the most as a result of the new guid-ance.

Identifying Performance Obligations

Technology companies often enter into arrangements that include several differ-ent performance obligations and are required to assess the contract and identifyeach one. Under the new guidance, the process of identifying separate perfor-mance obligations is less restrictive than the process of identifying a separatedeliverable under current U.S. GAAP. Thus, these companies may find that their



typical arrangements are divided into a larger number of obligations, each ofwhich is accounted for separately.

Long-Term Contracts for the Customization of Software

Under the new rules, in the context of a long-term contract (i.e., software cus-tomization), revenue could be recognized continually over time if the reportingentity is able to demonstrate that its performance creates or enhances an assetthat the customer controls as the asset is created or enhanced. As the IT systemis on the customer’s premises, and the customer controls the system while thecustomization efforts are taking place, there may be many situations where con-trol is transferred over the period of time that the customization is taking placerather than once it is completed.

Entities would still have to determine how many distinct performance obligationsexist and the proper manner to recognize revenue for each obligation (point intime or over time), which would require them to consider:

s Whether the customer originally receives a fully functioning software plat-form that the vendor is going to further customize for them;

s Whether the customer has the added flexibility of being able to hire otherentities to perform the customization; and

s The significance of the customization efforts (regardless of whether thecustomer can obtain those services elsewhere).

As the IT system is on the customer’s premises, and the customer controls

the system while the customization efforts are taking place, there may be

many situations where control is transferred over the period of time that the

customization is taking place rather than once it is completed.

An entity’s conclusions with respect to these factors may result in the identifica-tion of more/less performance obligations than under current U.S. GAAP andmay result in a change in the recognition model to/from a point in time from/toover time.

Licensing of Intellectual Property (‘‘IP’’)

The new standard contains specific guidance for revenue recognition for licensesof IP. Under the new rules, a license may or may not qualify as a separate per-formance obligation (depending upon whether it is distinct). If it does, a report-ing entity is required to analyze the nature of the promise and determine whetherthe license provides the customer with a right to use (which is a performanceobligation satisfied at a point in time) or a right to access its intellectual property(which is a performance obligation satisfied over time). Such a distinction wasestablished in the new standard as it was deemed necessary in order to determine



when the customer obtains control of the asset. This differs from current guid-ance which generally required IP licenses to be recognized over time as theyfailed to constitute a sale under existing guidance (i.e., the agreements were lim-ited to a term; were often non-exclusive; and/or were restricted to a specific in-dustry or geography).

Another area where the FASB provided specific guidance relevant to IP relatesto variable consideration (IP-related sales or usage based royalties). Generally,entities are required to estimate the amount of consideration to which they willbe entitled. For IP transactions with variable consideration, an entity will onlyinclude such consideration in the transaction price when the subsequent sales orusage occurs. This treatment differs from both current guidance and other areasunder the new standard (including royalties for non-IP related services).

Allocating Transaction Price

The new rules eliminate the requirement that an entity must have vendor specificobjective evidence (VSOE) of fair value in order to avoid revenue deferral in asoftware arrangement. There are no longer software-specific revenue recognitionrules. Instead, software arrangements will be subject to the same rules as othercontracts with customers. Thus, a software company will analyze a contract todetermine the separate performance obligations and will allocate consideration toeach obligation based on its stand-alone selling price.

With respect to allocation, the new rules will likely accelerate revenue in manycases because companies that now have to defer revenue (because there is noVSOE of fair value) will be able to recognize revenue earlier.

Under the new rules, a reporting entity is required to capitalize incremental

costs of obtaining a contract unless the limited practical expedient applies.

Although these changes may affect companies across many industries,

companies in the software and technology industries may be most

significantly affected.

Accounting for Contract Costs

Under the new rules, a reporting entity is required to capitalize incremental costsof obtaining a contract unless the limited practical expedient applies. For compa-nies that currently expense incremental contract acquisition costs and othercustomer-related costs, the new rules will necessitate systems to separate andtrack the incremental costs of obtaining a contract with a customer as well assystems to continually assess amortization periods and impairment. Althoughthese changes may affect companies across many industries, companies in thesoftware and technology industries may be most significantly affected.



Illustration A: Comprehensive Example

If an organization has an arrangement that contains a provision for hardware,software and ongoing professional services, how should revenue be recognizedfor each promised good or service?

Under the new guidance, each promised good or service may be considered aperformance obligation. Alternatively, one or more of the promised goods or ser-vices could be bundled with others into one performance obligation. The relevantinquiry is whether each promised good or service is ‘‘distinct.’’ Managementjudgments and estimates regarding each good or service are important factors indetermining the proper revenue recognition treatment. The new revenue modeluses broad principles rather than prescriptive rules.

Assume a company signs a contract for the sale of computer hardware, softwareand post contract customer support (PCS) for $25,000. Determining the numberof performance obligations may be different under the new standard as each obli-gation will have to be ‘‘distinct.’’ If, for example, the entity never sells the hard-ware separately it may determine that the hardware is not a distinct element (i.e.,it is simply integral to the delivery of the hosted software).

In addition, under previous guidance, the software industry was required to pro-vide VSOE of selling price (i.e. fair value) for each element. As PCS typicallywas never sold on a stand-alone basis, companies typically failed to meet thiscriterion and were required to recognize all of the transaction consideration rat-ably over the PCS period (thereby delaying the recognition of revenue on anydelivered elements).

If the company is able to demonstrate that each of the three items constitutes aperformance obligation, it can allocate the total transaction price based on therelative stand-alone selling prices of the computer hardware ($12,000), the soft-ware ($8,000), and the PCS ($5,000 for a 12 month contract). The company isable to recognize revenue once the transfer of control occurs for each element.In this instance, the transfer of control for the hardware would occur upon pos-session by the customer. The transfer of control of the software could be:

i. At a point in time (the day it is delivered with the hardware) if it is distinctand it will remain fully functional over the PCS period without further updates,or

ii. Over time (over the PCS period) if it is a hosted arrangement or it necessi-tates regular updates to remain functional over the overall contract period.

Finally, revenue from the provision of PCS would be recognized ratably over theterm of the contract.

At the time of the transfer of control:

a) DR. Accounts Receivable $12,000



CR. Revenue—Hardware $12,000

DR. COGS $10,000

CR. Inventory $10,000

b) DR. Accounts Receivable $8,000

CR. Revenue—Software $8,000

After first month of support

c) DR. Accounts Receivable $416

CR. Revenue—PCS $416

This example could have several other outcomes depending on the company’sability to decipher a ‘‘stand-alone selling price’’ and the ability to demonstrate a‘‘transfer of control’’ on any one or all of the three of the promised goods orservices.

Illustration B: Bundled Goods and Servives

Assume a company signs a contract for the sale of computer hardware, softwareand PCS for $25,000. Assume that the software and the PCS are not distinctwithin the context of the contract. For example, the software developers are theonly ones who have access to the software code and as part of the ongoing PCS,they are required to make integral modifications to the software on a monthlybasis. Since the customer is not able to purchase the goods separately from theother consistently delivered services, the software and PCS would be bundledinto one performance obligation satisfied over time.

On a monthly basis as the PCS is rendered:

d) DR. Accounts Receivable $1,083 (($8,000 + $5,000)/12)

CR. Revenue—Software $667

CR. Revenue—PCS $416

Illustration C: Cost Capitalization

Assume a company signs a contract for the sale of computer hardware, softwareand post contract customer support (PCS) for $25,000. Assume that the stand-alone selling prices are as follows: computer hardware is ($12,000); software($8,000); and PCS ($5,000 for a 24 month contract). The company also pays$2,400 in costs to obtain the contract (i.e., sales commission). Assuming thecompany could demonstrate that the costs of obtaining the contract are recover-able, those costs would be recorded as an asset and amortized over the periodfor which the goods or services relate.

At the time the costs are paid:



a. DR. Contract Acquisition Costs $2,400

CR. Cash $2,400

Monthly

a. DR. Commissions Expense $100

CR. Contract Acquisition Costs $100

If the contract acquisition costs relate to a period of less than a year, an entitymay elect to expense them as incurred. Additionally, each reporting period, thecompany would have to evaluate the contract acquisition costs for recoverability.If an impairment exists then the costs would be reduced to their recoverableamount (if any exists).



Media&Entertainment

MEDIA AND ENTERTAINMENT

EisnerAmper LLP

By Marc SabatesBy Dave Katz


The new revenue recognition guidance will likely have a profound impact on theMedia and Entertainment Industry. The issues noted below are those areas wherethe Media and Entertainment Industry is expected to be impacted the most as aresult of the new criteria.

Identifying the Contract

The new guidance allows for oral or implied contracts, if that is a customarypractice of the entity. The concept of creating an enforceable right, which maybe a question of law, was introduced into revenue recognition guidance, and thisis particularly relevant when unwritten contracts are used between the parties.The FASB stated that while a contract must represent a legally enforceable right,the entity may satisfy the relevant criteria based on valid customer expectations.Therefore, if it is common for the seller to begin performance on a contract

MEDIA & ENTERTAINMENT


when contacted orally by a customer (with more formal documentation to fol-low), recognition of revenue may begin to occur as soon as performance beginseven if the notification of the contract is pending.

Contract Modification

When a contract or arrangement is modified, consideration needs to be given towhether the modification should be reflected in the accounting for the initial con-tract or whether it represents a new contract. Current guidance lacked specificrules on contract modifications and practitioners were left to their judgment as tohow to account for the modification. The new standard provides specific guid-ance to enable companies to determine whether a modification in scope or pricerepresents a new contract or is part of the existing contract. If it is determined tobe a new contract, it is accounted for separately. The guidance is potentially te-dious when the modification is considered to be part of an existing contract, andthe accounting for such a modification can range from adjusting for the modifi-cation prospectively to having to make a cumulative adjustment on the modifica-tion date to properly reflect previously recognized revenues.

The [new revenue] guidance is potentially tedious when [a contract]

modification is considered to be part of an existing contract, and the

accounting for such a modification can range from adjusting for the

modification prospectively to having to make a cumulative adjustment on the

modification date to properly reflect previously recognized revenues.


While the concept of performance obligations initially appears analogous tostand-alone value under historical guidance, further consideration as to whetherto combine goods and services into one performance obligation becomes an im-portant factor in revenue recognition. Under the new standard, distinct goods orservices that have the same pattern of delivery to the customer will be combinedinto one performance obligation if they meet certain criteria. Distinct goods andservices are combined if both of the following criteria are met:

i. Each distinct good or service in the series that the entity promises to transferconsecutively represents a performance obligation that would be satisfied overtime if it were accounted for separately; and

ii. The entity would measure its progress toward satisfaction of the performanceobligation using the same measure of progress for each distinct good or servicein the series.

The introduction of this concept will have more significant impact in instanceswhere the consideration is variable. For example, for companies offering free



goods or services with their long-term contracts, the new guidance will changethe timing of revenue recognition based on this principle. Revenue is to be rec-ognized based on actual performance, as opposed to straight-line over a period,with revenue being allocated to the free portion. Therefore, if the free portion isdelivered up-front, revenue recognition may be accelerated. If the free portion isdelivered over a period of time, the value will be allocated and recognized asdelivered.

Determining the Transaction Price

The new guidance significantly changes revenue recognition for those companieswith variable consideration. Under the new approach, with limited exceptions, anentity includes its estimate of variable consideration in transaction price to theextent that it is probable that a subsequent change in estimated variable consider-ation would not result in a significant reversal in the amount of cumulative rev-enue recognized. Current guidance does not allow for recognition until contin-gencies are resolved.


Under current guidance, the transaction price is typically allocated to the perfor-mance obligations in proportion to their standalone selling prices. Discounts areproportionally allocated to each element in a multiple-element arrangement. Un-der the new guidance, this will generally be the case as well; however the FASBdid provide specific guidance and examples where a discount may be attributedto only some (or even one) performance obligation. Specifically, if an entity isable to meet three prescribed criteria, the entity will allocate the discount to oneor more, but not all, performance obligations. For example, a media entity offersthree deliverables, say X, Y and Z and they are sold for $10, $20 and $30 re-spectively. In addition, to selling these items individually they sell products Y &Z in a bundle (‘‘Bundle A’’) for a total of $30 (a discount of $20) and all three(‘‘Bundle B’’) for $40 (a discount of $20). The company considers the facts,which include:

s The individual selling prices of the deliverables;

s The selling price of Bundle A; and

s The selling price of Bundle B.

Upon reflection, the entity determines that the selling price of item X is com-pletely independent of Y&Z and that the entire discount inherent in Bundle Brelates to products Y and Z. As such, when selling Bundle B, the purchase priceof $40 would be allocated to X ($10); Y ($12); and Z ($18). This would be cal-culated as follows:

s The $20 discount when selling Bundle B would be attributed to productsY & Z as those two products are independently sold (in Bundle A) for a discountof $20. As such, the normal selling price for product X ($10) would be used.

s The remaining consideration ($30) would be allocated to products Y & Zbased upon their stand-alone selling prices ($20 and $30 respectively, a total of



$50). As such, the amount allocated to Y would be $12 ($20 stand-alone price ÷$50) and Z would be $18 ($30 stand-alone price ÷ $50).

These results differ from current guidance, which would spread the considerationout over all of the deliverables resulting in an allocation of $6.67 (product X);$13.33 (product Y); and $20.00 (product Z). This is a significant change fromcurrent practice, and media and entertainment companies will have to criticallyevaluate how they package and bundle their various products and services.

Satisfying the Performance Obligation

The new guidance provides assistance in determining whether a performanceobligation is satisfied over time or at a point in time. In addition, the FASB alsointroduced the concept of creating an enforceable right to payment for perfor-mance completed to date. A customer’s obligation to pay for the entity’s perfor-mance, even in the presence of a cancellation provision, is an indicator that thecustomer has obtained benefit from the entity’s performance. This may result inthe acceleration of revenue recognition.

Direct-Response Advertising

Under the new rules, all advertising costs, including direct-response would beexpensed as incurred (except for direct-response advertising for insurance enti-ties). This differs from current guidance where certain direct response advertisingcosts are capitalized and amortized over the future benefit period under certainconditions.

Illustration A: Transaction Price—Allocation of a Discount

A media company enters into a contract to provide comprehensive advertising toa customer for $250,000. The contract includes an ad on its website, a radio ad-vertisement and a television spot. Assume that the standalone selling price ofeach of the three items is $100,000. How should the transaction price for eachgood or service be determined?

There are three performance obligations since each of the promised goods orservices is ‘‘distinct’’—the customer receives value independently for each.Since the total contract price ($250,000) is less than the total standalone value ofeach component, there appears to be a discount provided on the contract. If weassume that the entity is unable to demonstrate that the price of a specific perfor-mance obligation is largely independent of the other obligations (and, therefore,the discount would be attributed to only one or two of the performance obliga-tions), the company would allocate this discount to each performance obligationby multiplying the standalone selling price by the total discount percentage:

$100,000 x ($250,000/$300,000) = $83,333

Revenue is then recognized as each performance obligation is satisfied.

How would revenue recognition differ if an ad on the website was not regularlysold separately?



Even in the case where an ad on the website is not regularly sold separately, rev-enue recognition would remain the same. The company would apply its estimateof standalone selling price of the website ad and allocate the contract based onthat estimate.

Illustration B: Transaction Price—Estimating Variable Consideration

A company enters into a three-month, $1,000,000 fixed fee contract to providemarketing services for a customer. If certain goals are attained during the period,the company would receive an additional $1,000,000. How should the companyrecognize the $1,000,000 performance bonus?

The company can use one of two approaches to determine the amount of theperformance bonus to be included in the transaction price:

(1) Use a probability-weighted estimate. For instance, if there was a 50% chancethe company would receive the bonus and a 50% chance the company wouldreceive nothing:

(1,000,000 x 50%) + (0 x 50%) = $500,000

$500,000 would be included in the transaction price, and $1,500,000 would berecognized as the services are delivered.

(2) Use a most-likely approach. For instance, if the company believes that theywill receive the bonus, the entire $1,000,000 would be included in the transac-tion price, and $2,000,000 would be recognized as the services are delivered.

Under each approach, the transaction price would be adjusted for any changes inthe value of the estimate.

Illustration C: Contract Modification

A distribution company contracts to deliver 25,000 promotional buttons for$100,000 ($4 per button) over the course of a year. After the initial 15,000 ship-ment, the terms are modified and the company is to distribute another 5,000 for$2 per button (30,000 total). At the time of the contract modification, $2 per but-ton is the standalone selling price. How should revenue for the additional 5,000buttons be recorded?

The contract modification is a new contract that does not affect how the originalcontract is recorded because the new price is the then standalone price.

How would revenue be recorded if $2 was not the standalone value?

If the modification price ($2) is not the standalone value, then the modifiedtransaction price would need to be allocated to the remaining items not yet deliv-ered as follows:

Number of buttons remaining – 15,000 (25,000–15,000 + 5,000)

Blended price = [($4 x 10,000) + ($2 x 5,000) / 15,000] = $3.33



Aerospace&Defense

AEROSPACE AND DEFENSE

Chess Consulting LLCBy David F. HessBy Carin C. Craun

Chess Consulting is a specialized independent consulting firm offering a uniquecombination of government contracting regulatory expertise, complex accountingand financial reporting knowledge, business systems and risk management expe-rience along with forensic accounting and expert testimony services. David F.Hess is a managing director at the company, and Carin C. Craun, is a director.

Background and Introduction

As a result of the new standard, aerospace and defense (A&D) companies willneed to perform a careful assessment of their contract population including thenature of the goods and services provided, related contract commitments and theunderlying economics of each contract to properly identify the implications ofthis new standard. This assessment process will be challenging as many A&Dcompanies have hundreds, if not thousands of contracts, including numerouscomplex long-term construction and production-type contracts that may spanover a number of years. These contracts often include priced and un-priced op-tions, provisions for award fees and incentive fees or other unique elements. Inaddition, change orders and claims are often encountered during the performanceof A&D contracts.

AEROSPACE & DEFENSE


Aerospace and defense companies will need to perform a careful assessment

of their contract population including the nature of the goods and services

provided, related contract commitments and the underlying economics of

each contract to properly identify the implications of this new standard.

This portion of the Report highlights some of the key accounting implications ofthe new standard for the A&D industry, including certain differences and simi-larities with the prior standard, ASC 605-35, Revenue Recognition –Construction-Type and Production-Type Contracts (ASC 605-35), formerlyknown as SOP 81-1. As will be discussed, there are a number of accounting con-cepts within the new standard that are similar to the accounting previously pro-vided for under ASC 605-35, yet certain changes and challenges will be experi-enced and may vary significantly depending on the company’s current revenuerecognition policies. Under the new standard management is required to usemore judgments and estimates in recognizing revenue, which may be a challengefor some industries, but fortunately is something the A&D industry is accus-tomed to. The ability of companies within the A&D industry to make reasonablemanagement judgments and estimates is typically supported by strong proce-dures, internal controls, and knowledgeable personnel, not only in the financefunction, but throughout an organization including contract administration, proj-ect management and production control. This familiarity should serve the indus-try well in assessing and adopting the new standard.

Key Accounting Implications

I. Identifying Performance Obligations

Under ASC 605-35, the basic presumption was that the contract represents theunit of accounting or ‘‘profit center’’ when measuring income unless, under cer-tain circumstances, the contract may be combined with two or more contracts orsegmented into distinct elements. With the new standard, the unit of accountingwill be tied to the ‘‘performance obligation’’ identified. A performance obligationis defined as a promise (implicit or explicit) in a contract with a customer totransfer a good or service to the customer that is distinct. Identifying separateperformance obligations requires that entities assess and identify each promise totransfer to the customer either (1) a good or service (or a bundle of goods orservices) that is distinct or (2) a series of distinct goods or services that are sub-stantially the same and have the same pattern of transfer to the customer.

Goods and services may be considered distinct if the customer can benefit fromthe contracted goods and services either on its own or together with other re-sources readily available to the customer. The new standard also requires that theidentification of a performance obligation be assessed across related contracts. It



is likely that more contracts will be required to be combined when such con-tracts include a single performance obligation entered into at or near the sametime with the same customer where the pricing or economics of the contracts areinterdependent.

Under the new standard, an entity should account for a bundle of goods or ser-vices as a single performance obligation if the goods or services are highly inter-related, the entity provides a significant service of integrating them into a com-bined item or items, or they are significantly modified or customized to fulfill thecontract.

A&D contracts are typically with a single customer, the U.S. Government, andoften include the design, development, manufacturing or modification of com-plex equipment and systems to a buyer’s specifications, or provide for custom-ized services highly related to the performance of the contract. These contractsshould clearly meet the test of being highly interrelated with significant modifi-cations or customization to fulfill the contract. Due to the nature of A&D con-tracts, the new standard may typically result in the identification of a single per-formance obligation within a contract. However, each contract must be carefullyanalyzed after considering all of the facts and circumstances in determiningwhether distinct performance obligations exist within a contract. For example, ifa contract required the contractor to manufacture five pre-engineered and de-signed aircraft, where limited design changes are expected, then each aircraftmay arguably be considered distinct and therefore accounted for as five separateperformance obligations. In addition, if the contract also included post produc-tion maintenance and repair services, then those additional services will likely beaccounted for as distinct performance obligations. The identification of distinctgoods and services and the potential interrelationship of the deliverables withinthe contract, as well as the level of customization required, are critical aspects tounderstand and assess.

Illustration A:

A satellite manufacturer enters into a $250 million contract with the U.S. Gov-ernment to design and manufacture three weather satellites. The contractor an-ticipates significant design changes and modifications to their existing satellitebusiness. Because of the high level of customization and the highly interrelateddesign and production phases, the contractor has determined that the goods andservices under the contract represent a single distinct performance obligation.

Two months after the initial contract award, the contractor enters into a new$160 million contract with the same customer to manufacture two additional sat-ellites similar in design to those under the original contract. Because of the tim-ing of the new award it is construed to be negotiated as a package with a com-mon objective despite the fact that the price per unit is lower than the originalthree satellites. Additionally, since performance of the second contract dependsupon the performance of the first, the contractor concludes that it must combinethe two contracts.

AEROSPACE & DEFENSE


II. Determining and Allocating Transaction Price to Performance Obligations

The transaction price is defined as the amount of consideration that an entityexpects to be entitled to in exchange for transferring promised goods or servicesto a customer, excluding amounts collected on behalf of third parties. At contractinception, when determining the transaction price, companies not only need toconsider the stated contract price but must also identify and assess the estimatedamount of variable consideration expected to be realized by using either aprobability-weighted or most-likely approach, as defined in the standard. Thevaluation approach selected to estimate variable consideration should be appliedconsistently throughout the life of the contract and on similar types of variableconsideration.

Variable consideration for A&D contracts typically will result from contract pro-visions for penalties and incentive payments, including award fees and perfor-mance incentives. The inclusion of an estimated amount of variable consider-ation in the transaction price should not create the risk of ‘‘significant revenuereversal.’’ The entity shall consider both the likelihood and the magnitude of therevenue reversal. Factors that could impact the likelihood or the magnitude in-clude but are not limited to, any of the following:

s Extent of an entity’s past performance or experience;

s Amount of time until the uncertainty is resolved;

s Susceptibility of the outcome to factors outside the influence of the com-pany; and

s Number and variability of possible consideration amounts.

The entity shall include in the transaction price the amount of variable consider-ation only to the extent that it is probable that a significant reversal in theamount of cumulative revenue recognized will not occur when the uncertainty issubsequently resolved. This amount may be zero, some or all of the variableconsideration determined using one of the selected estimating approaches dis-cussed above. Consistent with past practice under ASC 605-35, entities will needto continuously update their estimates of the final expected revenue, includingthe variable consideration to be realized throughout the contract performanceperiod.

Sales by A&D companies may include financing arrangements where the timingof cash flows from the customer may not correspond with the revenue recogni-tion timing. Under the new standard, if there is a financing component, eitherexplicitly or implicitly, that is significant to the contract then the time value ofmoney must be determined and accounted for separately from revenue. The stan-dard does not require that the time value of money be considered in determiningthe transaction price if the period between customer payment and transfer ofgoods or services is one year or less.

Once the total transaction price is determined, the entity will allocate the price tothe identified performance obligations based on the amount of consideration the



entity expects to be entitled to in exchange for satisfying each performance obli-gation. Under prior accounting standards, the separately negotiated prices for thedifferent contract components were generally used to value separate contract ele-ments. Under the new standard, when standalone selling prices are not directlyobservable, an entity shall estimate the standalone price. Suitable methods forestimating the standalone selling price include the adjusted market assessmentapproach, the expected cost plus a margin approach or in certain circumstances,if the price is highly variable or uncertain, the residual approach. For variableconsideration, the new standard requires that the transaction price include anamount to be allocated to a specific performance obligation if both (1) the vari-able payment relates to the entity’s efforts to satisfy a specific performance obli-gation or a specific outcome from satisfying that performance obligation and (2)the result of the allocation is consistent with the basic principle that allocatedconsideration reflects the amount that the entity expects to be entitled to in ex-change for satisfying each individual performance obligation.

The determination of the transaction price, including the estimated variable con-sideration, should be fairly straightforward for A&D companies although thetotal estimated amount of variable consideration may be lower or more conserva-tively estimated than under ASC 605-35 due to the ‘‘significant revenue rever-sal’’ constraint discussed above. The requirement to allocate the transaction pricewhen multiple performance obligations within a contract are identified may rep-resent a significant change in practice for certain contracts within the A&D in-dustry. However, as discussed above in Section (1), many A&D contracts pro-vide for customized solutions where the performance obligation, and thereforeunit of accounting, may continue to be at the contract level and thus no alloca-tion should be required.

Illustration B:

Assume the facts in Illustration A, above. Assume the following additional facts:The contract(s) now contains incentive awards for the on-time delivery of eachsatellite ($3 million per satellite), and Engineering and Production estimate thereis an 80 percent probability that each satellite will be delivered on-time basedupon past performance and consideration of the current environment.

Taking into consideration the Engineering and Production estimate, its own as-sessment and the binary nature of the outcome (i.e., on-time delivery award ornot), management determines the best predictor is the ‘‘most likely amount’’ andtherefore the entire incentive award amount would be recognized in the transac-tion price. Therefore, at contract inception, the total transaction price would be$425 million = [$250 million + $160 million + (5 * $3 million)].

III. Determining if the Transfer of Control is Over Time and Measuring ProgressTowards Completion

Based on the new standard, an entity recognizes revenue when or as it satisfiesthe performance obligation(s) by transferring control of a good or service to a

AEROSPACE & DEFENSE


customer. The three specific scenarios in which controls transfers continuouslyover time and therefore revenue will be recognized over time are when: (1) thecustomer receives and consumes the benefits of the seller’s performance as theseller performs; (2) the seller is creating a ‘‘work in progress’’ asset which iscontrolled by the customer; and (3) the seller is creating a ‘‘work in progress’’asset which could not be directed to a different customer and the customer hasan obligation to pay for the entity’s work to date. If the transaction does not fitinto one of these scenarios, then control transfers, by default, at a point in timeand revenue will be recognized at that point in time. For A&D contracts with theU.S. Government, control over the goods being manufactured is typically re-tained by the customer. However, contracts that fall within scenario three abovewill require careful consideration of the contractual terms that may allow thecustomer to terminate, curtail or significantly modify a contract, and whether theseller would be entitled to adequate payment for the work performed to date.

For a performance obligation satisfied over time, the objective is to recognizerevenue in a manner that depicts the transfer of control of the goods or servicespromised to the customer. As a general proposition, contractors will be able toutilize the same progressing methods that were utilized under ASC 605-35 whichinclude (1) input methods that recognize revenue on the basis of the entity’s ef-forts or inputs to the satisfaction of a performance obligation relative to the totalexpected inputs (for example, costs incurred or labor hours expended); and (2)output methods that recognize revenue on the basis of direct measurements ofthe value to the customer of the goods or services transferred to date relative tothe remaining promised under the contract (for example, units produced or deliv-ered or contract milestones). Under the new standard the progressing methodused should be consistently applied to similar performance obligations and insimilar circumstances. Within the A&D industry, the cost-to-cost method maycontinue to best depict the continuous transfer of goods and services for many oftheir contracts.

Similar to ASC 605-35, the cost-to-cost method under the new standard will al-low for contract cost to generally be recognized as incurred, although certaincosts that may not depict the transfer of goods and services, such as ‘‘wastedcosts’’ and ‘‘uninstalled materials,’’ will need to be identified and evaluated forappropriate treatment. ‘‘Wasted costs’’ may include items that are typicallypriced into an A&D contract such as anticipated rework. However, significant ornotable amounts of wasted costs that were not considered in the transaction priceand original estimate-at-completion should be expensed as a period cost. Thecost of ‘‘uninstalled materials,’’ including long-lead items or scarce materialsprocured in advance of use or installation, should be evaluated and excluded asappropriate when an input method based on costs incurred is used to measure itsprogress towards completion, as the cost incurred is not proportionate to the enti-ty’s progress in satisfying its performance obligation(s).

A&D companies must assess their current method(s) for measuring progress toensure they properly depict the transfer of control of goods and services includedin the related performance obligation and that they are appropriate under the new



standard. For example, certain percentage-of-completion measurement and ac-counting methods currently allowed under ASC 605-35 may no longer be accept-able, such as the Alternative B calculation method, the use of lot accounting oraverage unit costing, program accounting and the reallocation method.

A&D companies must assess their current method(s) for measuring progress

to ensure they properly depict the transfer of control of goods and services

included in the related performance obligation and that they are appropriate

under the new standard. [C]ertain percentage-of-completion measurement

and accounting methods currently allowed under ASC 605-35 may no longer

be acceptable.

IV. Accounting for Contract Modifications

Due to the complexity of contracts or projects within the A&D industry, contractmodifications including formal and constructive change orders are common; con-tract options, including priced and unpriced options, are often times incorporatedinto the base contract; and claims may arise from disputes over unapprovedchange orders. A contract modification is defined as an approved change in thescope and/or price of a contract. Under the new standard, the accounting treat-ment of a modification will depend on its characteristics. More specifically, amodification may be treated as a separate performance obligation when the scopeincreases as a result of the sale of additional distinct goods and services and therelated consideration reflects the company’s standalone selling price. If the modi-fication is not considered a separate performance obligation and only relates togoods or services not yet transferred at the date of the modification, then theprice change would be allocated to the remaining performance obligations basedon the allocation method used at contract inception. However, if the same modi-fication discussed above relates to goods or services that are partially satisfiedthen a cumulative catch-up adjustment must be recognized.

Under the new standard, changes in the scope of the contract may be approvedin writing, orally, or implied, based on customary business practices, in order toqualify for recognition. This higher recognition threshold for modifications inscope may cause a delay in the recognition of revenue as compared to past prac-tices where recognition was based on when the change was deemed ‘‘probable orreasonably assured.’’

Contract options or an addition to an existing contract should be analyzed andtreated in a similar manner as change orders. If there is an option in the originalcontract then the same analysis as discussed above regarding change orders andwhether it relates to an existing or separate performance obligation must be per-formed. In addition, if it is a priced option, consideration should be given as to

AEROSPACE & DEFENSE


whether the option price and anticipated cost relationship and related economicjudgments used to set the price are significantly different from the original con-tract. If the option price is considered similar, then the option may be combinedwith the related performance obligation identified in the original contract.

With respect to contract claims, unlike ASC 605-35, there is no specific guidanceprovided in the new standard. Therefore, any claim would be evaluated as anunapproved contract modification. A&D companies will have to evaluate con-tract claims similar to other contract modifications and use their judgment todetermine when and how much of a claim to recognize, based on an assessmentof the legal basis of the claim, its enforceable rights under the contract and otherrelevant facts and circumstances. This may result in a significant delay in rev-enue recognition compared to the accounting allowed for claims under ASC 605-35.

Illustration C:

Assume the facts in Illustration A, above. Assume further that six months intothe contract, during the design phase, the customer and contractor identify sig-nificant design changes and enhancements to be added to the contract for all fivesatellites. The contractor subsequently receives an executed change order outlin-ing the revised design specifications and the related price increase ($40 million).

Since all five satellites are part of a single performance obligation, one in whichperformance is partially satisfied as of the date of the modification, the contrac-tor would account for this modification as if it were part of the original contract.

Total CombinedContract

ContractModification

Total CombinedContract

w/ ModificationContract Revenue $ 410 $ 40 $ 450Estimated Cost 350 30 380Estimated Profit $ 60 $ 10 $ 70

As of the date of the contract modification, the contractor had incurred $35 mil-lion of cost (satisfied 10% of its progress toward completion under the cost-to-cost method). As a result of the modification, the contractor updates its measureof progress and estimates that it has satisfied 9.21% of its performance obliga-tion ($35 million cost incurred ÷ $380 million revised estimated cost). The con-tractor would record a cumulative catch-up adjustment and recognize additionalrevenue of $0.45 million ((9.21% * $450 million) - $ 41 million) at the date ofthe modification as shown below.



RevenueRecognized

BeforeModification

RevenueRecognized

AfterModification

CumulativeCatch-Up

AdjustmentContract Revenue $ 41 $ 41.45 $ 0.45Estimated Cost 35 35 0Estimated Profit $ 6 $ 6.45 $ 0.45

Note: If the change order only pertained to the final three satellites as the firsttwo were already in production then the contractor would revise the transactionprice (allocating the value of the contract modification) for the three remainingsatellites and recognize the revenue on a prospective basis.

V. Assessing the Impact of Expanded Disclosure Requirements

The new disclosure requirements are significantly more extensive and detailed.These disclosures are intended to enable users of financial statements to under-stand the nature, amount, timing, and uncertainty related to revenue and the cor-responding cash flows arising from contracts with customers. The disclosureswill include qualitative and detailed quantitative information about contracts,such as the disaggregation of revenue into categories including, but not limitedto type of goods or service, geography, market or type of customer, type of con-tract and contract duration. Specific disclosures about performance obligationsare required, including when an entity is expected to satisfy its performance obli-gations, any significant payment terms and if obligations for returns/refunds andwarranties exist.

Another new disclosure which may be particularly difficult for A&D companiesrelates to contracts expected to be completed more than one year from contractinception. Companies will be required to disclose the amount of the transactionprice allocated to the remaining performance obligations (unsatisfied or partiallyunsatisfied) as of the end of the reporting period, as well as explanation or dis-cussion of when the entity expects to recognize those amounts as revenue.

A&D companies will find the new annual and interim disclosure requirements

to be excessive, which may cause significant challenges in applying the

requirements to large and complex long-term contract environments.

In essence, this will require A&D companies to time phase their contract backlogand include the forecasted information in their financial statements, which willrequire external auditors to audit the underlying data and related assumptions.A&D companies will find the new annual and interim disclosure requirements to

AEROSPACE & DEFENSE


be excessive, which may cause significant challenges in applying the require-ments to large and complex long-term contract environments.

Conclusion

The final interpretation and identification of issues an A&D company will needto assess and plan for may vary significantly depending on its current revenuerecognition policies and practices. If a full retrospective application of the newstandard is elected, companies will be required to assess and restate all contractsin process during each of the two years prior to the effective date to determinethe revenue recognition impact upon adoption. Essentially, a separate set of re-cords will need to be created, including the supporting processes and systems tocapture and report the revisions to the historical contract accounting records. Inaddition, A&D companies may need to develop new systems, processes and con-trols to track and report the required detailed disclosures, as discussed above.

If A&D companies have not already begun to prepare for the adoption of thisnew standard, they should immediately begin to inventory and assess the impactof the related modifications that will be required to be added to their current ac-counting policies, procedures, systems and processes. In addition, companiesshould consider modeling the impact of each of the two implementation methodsprovided for in the standard to help assess and make an informed decision on thebest approach for the entity.

If A&D companies have not already begun to prepare for the adoption of this

new standard, they should immediately begin to inventory and assess the

impact of the related modifications that will be required to be added to their

current accounting policies, procedures, systems and processes.

Prior to the effective date of the new standard, AICPA industry and other guid-ance is being developed to assist with the interpretation and implementation ofthe standard. In addition, companies under U.S. GAAP may benefit from theability to assess issues and challenges resulting from the early adoption of thenew standard by foreign filing issuers, given that the International AccountingStandards Board has allowed for early adoption of the standard.



Life Sciences

LIFE SCIENCES

EisnerAmper LLPBy Marc SabatesBy Marc Fogarty


The new revenue recognition guidance will likely have a profound impact on theLife Sciences Industry. The issues noted below are those areas where the LifeSciences Industry is expected to be impacted the most as a result of the new cri-teria.

Identifying the Contract

The new guidance allows for oral or implied contracts, if that is a customarypractice of the entity. The concept of creating an enforceable right, which maybe a question of law, was introduced into revenue recognition guidance, and thisis particularly relevant when unwritten contracts are used between the parties.The FASB stated that while a contract must represent a legally enforceable right,the entity may satisfy the relevant criteria based on valid customer expectations.Therefore, if it is common for the seller to begin performance on a contractwhen contacted orally by a customer (with more formal documentation to fol-

LIFE SCIENCES


low), recognition of revenue may begin to occur as soon as performance beginseven if the edification of the contract is pending.

Contract Modification

When a contract or arrangement is modified, consideration needs to be given towhether the modification should be reflected in the accounting for the initial con-tract, or whether it represents a new contract. Current guidance lacked specificrules on contract modifications and practitioners were left to their judgment as tohow to account for the modification. The new Standard provides specific guid-ance to enable companies to determine whether a modification in scope or pricerepresents a new contract or is part of the existing contract. If it is determined tobe a new contract, it is accounted for separately. The guidance is potentially te-dious when the modification is considered to be part of an existing contract, andthe accounting for such a modification can range from adjusting for the modifi-cation prospectively, to having to make a cumulative adjustment on the modifi-cation date to properly reflect previously recognized revenues.


While the concept of performance obligations initially appears analogous tostand-alone value under historical guidance, further consideration as to whetherto combine goods and services into one performance obligation becomes an im-portant factor in revenue recognition. Under the new Standard, distinct goods orservices that have the same pattern of delivery to the customer will be combinedinto one performance obligation if they meet certain criteria. Distinct goods andservices are combined if both of the following criteria are met:

i. Each distinct good or service in the series that the entity promises to transferconsecutively represents a performance obligation that would be satisfied overtime if it were accounted for separately; and

ii. The entity would measure its progress toward satisfaction of the performanceobligation using the same measure of progress for each distinct good or servicein the series.

The introduction of this concept will have more significant impact in instanceswhere the consideration is variable. For example, for companies offering freegoods or services with their long-term contracts, the new guidance will changethe timing of revenue recognition based on this principle. Revenue is to be rec-ognized based on actual performance, as opposed to straight-line over a period,with revenue being allocated to the free portion. Therefore, if the free portion isdelivered up-front, revenue recognition may be accelerated. If the free portion isdelivered over a period of time, the value will be allocated and recognized asdelivered.

Determining the Transaction Price

The new guidance significantly changes revenue recognition for those companieswith variable consideration. Under the new approach, with limited exceptions, an



entity includes its estimate of variable consideration in the transaction price tothe extent that it is probable that a subsequent change in the estimated variableconsideration would not result in a significant reversal in the amount of cumula-tive revenue recognized. Current guidance does not allow for recognition untilcontingencies are resolved. Under certain circumstances, including arrangementswith milestone payments, the new guidance will allow for accelerated revenuerecognition.

The new guidance significantly changes revenue recognition for those

companies with variable consideration. Under certain circumstances,

including arrangements with milestone payments, the new guidance will allow

for accelerated revenue recognition.


Under current guidance, the transaction price is typically allocated to the perfor-mance obligations in proportion to their standalone selling prices. Discounts areproportionally allocated to each element in a multiple-element arrangement. Un-der the new guidance, this will generally be the case as well; however the FASBdid provide specific guidance and examples where a discount may be attributedto only some (or even one) performance obligation. Specifically, if an entity isable to satisfy three prescribed criteria, the entity will allocate a discount to oneor more, but not all, performance obligations.

Satisfying the Performance Obligation

The new guidance provides assistance in determining whether a performanceobligation is satisfied over time or at a point in time. In addition, the FASB alsointroduced the concept of creating an enforceable right to payment for perfor-mance completed to date. A customer’s obligation to pay for the entity’s perfor-mance, even in the presence of a cancellation provision, is an indicator that thecustomer has obtained benefit from the entity’s performance. This may result inthe acceleration of revenue recognition.

Milestone Payments

As noted above, the new rules would require entities to estimate variable consid-eration at contract inception and allocate such consideration to performance obli-gations (to the extent that the constraint does not apply). Therefore, if a Com-pany deems a milestone payment to be more than likely, or can assign a prob-ability, revenue recognition can occur sooner (either 100percent of the paymentin ‘‘all or nothing’’ cases where it is deemed to be more than likely for a prob-able outcome, or a probability-weighted amount for other scenarios).

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Collaborative Agreements

The new rules do not further address whether collaborative arrangements repre-sent a contract with a customer, as they state that these types of arrangementsare not within the scope of the new standard. Companies will have to evaluatearrangements to determine whether the counterparty is a true collaborator (e.g.,they are sharing risks), or whether the counterparty is considered a ‘‘customer’’under the new guidance and, therefore, the revenue standard applies.

Illustration A—Allocation of a Discount

A company sells a medical device for $500,000. Included in the sale price isinstallation and a five-year service plan. The device is sold for $300,000 in theCompany’s routine course of business. While not sold separately, the five-yearservice plan is sold by others in the industry for $150,000. While not sold sepa-rately, installation for the device typically costs $100,000. How should the rev-enue be recognized?

There are three performance obligations since each promised good or service is‘‘distinct’’—the customer receives value independently for each. Since the totalcontract price ($500,000) is less than the total estimated standalone selling priceof each component, there appears to be a discount provided on the contract. TheCompany should allocate this discount to each performance obligation by multi-plying the estimated standalone selling price by the total discount percentage:

Device – $500,000 x ($300,000/$550,000) = $272,727

Service plan – $500,000 x ($150,000/$550,000) = $136,364

Installation – $500,000 x ($100,000/$550,000) = $90,909

Revenue is then recognized as each performance obligation is satisfied.

Assume, instead, that each of the three goods or services (the medical device,the service plan and the installation service) are sold separately. The contractincludes a discount of $50,000 on the overall transaction. Assume that the ser-vice plan and installation service are regularly sold as a bundle for $200,000.How is the discount allocated?

The Company has observable evidence that the discount should be allocated onlyto the service plan ($50,000 x $150,000/$250,000 = $30,000 discount) and theinstallation service ($50,000 x $100,000/$250,000 = $20,000 discount). The newrevenue guidance would require the Company to allocate the discount only tothose two obligations. Revenue would still be recognized as each performanceobligation is satisfied.

Illustration B—Performance Obligations

A research Company enters into a license contract to provide a license and re-search services. There is no history of selling either the license or the servicesseparately. The customer does not have the knowledge or ability to further ad-



vance the product and the Company is the only company able to perform theresearch services. How many service performance obligations are there?

There is only one service obligation (both the license and the research) becausethe customer cannot extract value from the license on its own, and can only doso utilizing the research services of the Company.

How would revenue recognition differ if the customer could outsource or inter-nally perform the research needed on the license?

In this case, the license and the research services are separate performance obli-gations because the customer can benefit from the license and research serviceson their own.

Illustration C—Transaction Price

A research Company enters into a license contract to provide a license to a cus-tomer. The Company will receive $5 million if the product under the license re-ceives FDA approval. Based on FDA communications and history of the Com-pany, management estimates that there is a 95 percent chance to be entitled tothe full payment and a 5 percent chance they will be entitled to no payment.Should the $5 million be included in the transaction price?

Under the new guidance, variable consideration is considered in the transactionprice. Since there are only two possible outcomes, utilizing the ‘‘most likely’’approach which appears to be the best indicator, the Company includes the $5million in the transaction price.

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