Finishing strong in the ASC 606 marathon: An in-depth look at Steps 1 and 2 of the new revenue model

Finishing strong in the ASC 606 marathon: An in-depth look at Steps 1 and 2 of the new revenue model Please disable popup blocking software before viewing this webcast Original Publication Date: Wednesday, April 26, 2017 CPE Credit is not available for viewing archived programs

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Speakers Lynne Triplett Partner +1 312 602 8060 lynne.triplett@us.gt.com Lori Turbe Partner +1 404 475 0200 lori.turbe@us.gt.com Sarah Merrill Director +1 404 475 0079 sarah.merrill@us.gt.com Julia Siegfriedt-Wilson Experienced Manager +1 312 602 8219 julia.siegfriedtwilson@us.gt.com Grant Thornton LLP. All rights reserved. 4

Finishing strong in the ASC 606 marathon webcast series Part 1 An in-depth look at designing for success (https://www.grantthornton.com/events/advisory/2017/04-18-new-revenue-standard-asc-606- marathon.aspx) Part 2 - Steps 1 and 2 of the new revenue model April 26, 2017 1-2:30 p.m. CT 1.5 CPE hours Part 3 - Steps 3 and 4 of the new revenue model May 10, 2017 1-2:30 p.m. CT 1.5 CPE hours Part 4 - Step 5 and contract costs May 23, 2017 1-2:30 p.m. CT 1.5 CPE hours To register for one or all of the webcasts, please visit www.grantthornton.com/events Part 5 - Licensing, modifications, and other potential hurdles June 13, 2017 1-2:30 p.m. CT 1.5 CPE hours Grant Thornton LLP. All rights reserved. 5

Learning objectives Describe the scope of the guidance in ASC 606 Analyze the five criteria to identify an accounting contract, including the collectability criterion Identify which promises constitute performance obligations in a contract Specify the accounting for contract options that provide material rights to customers Grant Thornton LLP. All rights reserved. 6

Who's in the race? Any entity that enters into contracts with customers to transfer goods or services Excludes: Insurance contracts Lease contracts Financial instruments Non-monetary exchange transactions Guarantees (other than product or service warranties) Grant Thornton LLP. All rights reserved. 9

Definition of a customer Customer A party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities in exchange for consideration. Grant Thornton LLP. All rights reserved. 10

Core principle An entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Grant Thornton LLP. All rights reserved. 11

Five-step model Identify the contract with a customer Identify the performance obligations Determine the transaction price Allocate the transaction price to the performance obligations Recognize revenue when or as an entity satisfies its performance obligations Grant Thornton LLP. All rights reserved. 12

Qualifying as an accounting contract Contract An agreement between two or more parties that creates enforceable rights and obligations May be: Written Oral Implied Grant Thornton LLP. All rights reserved. 14

Criteria to identify an accounting contract 1 Have the parties approved the contract and committed to perform their respective obligations? 2 Can the entity identify each party's rights? 3 Can the entity identify the payment terms? 4 Does the contract have commercial substance? 5 Is it probable that the entity will collect "substantially all" of the consideration to which it will be entitled? Grant Thornton LLP. All rights reserved. 15

Parties approve and commit to perform Contract might not be legally enforceable without approval of both parties Parties must be committed to performing their respective obligations Termination clauses must be considered A contract does not exist if both parties have the unilateral enforceable right to terminate a "wholly unperformed" contract without compensating the other party. Grant Thornton LLP. All rights reserved. 16

Example Free trial period Company enters into a 24-month service contract with the customer. The contract includes a one-month free trial period (for the first of the 24 months). During the first month the customer may cancel for no additional fee. After the end of the first month, the customer must pay a substantive termination penalty if it chooses to cancel. Past experience indicates the customer is unlikely to cancel. Does an accounting contract exist in month one? FREE TRIAL 30 DAYS No, there are no enforceable rights and obligations in that first month. Grant Thornton LLP. All rights reserved. 17

Example Master supply agreement Background: Entity A signs a 12-month master supply agreement (MSA) with its customer. The MSA prescribes general terms and conditions but does not specify minimum quantities. The MSA includes a price list for parts that Entity A agrees to supply to the customer for the next 12 months. Does the MSA pass Step 1? A MSA without a minimum purchase commitment will not pass Step 1. Grant Thornton LLP. All rights reserved. 19

Collectibility Objective: Is there a substantive transaction between the entity and the customer? Consider only the customer's ability and intention to pay substantially all of the consideration when due Consider only goods/services that will be transferred, not all of the promised goods/services Consider price concessions Grant Thornton LLP. All rights reserved. 21

Price concessions vs. collectibility issue Indicators that an entity is offering a price concession Past experience Customary business practices, published policies, or specific statements indicate that the entity will accept an amount of consideration that is less than the prices stated in the contract Intent Facts and circumstances indicate the entity's intention is to offer a price concession Grant Thornton LLP. All rights reserved. 22

Example Price concession vs. collectibility issue Background: Manufacturer enters into a long-term supply agreement with a customer. The contract specifies a price of $100 per part, however the manufacturer will customarily accept 20% less than the published price. A customer submits an order for 100 parts. o Contract price: $10,000 o Amount entity expects to be entitled to: $8,000 o Amount entity expects to collect: $8,000 Does a contract exist? Yes, the entity expects to collect substantially all of the consideration to which it is entitled. Grant Thornton LLP. All rights reserved. 23

When Step 1 criteria are not met Recognize revenue only when consideration received is nonrefundable and one of the following occurs: The entity's performance is complete and substantially all of the consideration has been collected. The contract has been terminated. NOT cash basis The entity has transferred control of the goods or services to which the consideration received relates, the entity has stopped transferring goods or services to the customer, and has no obligation under the contract to transfer additional goods or services. Grant Thornton LLP. All rights reserved. 24

Portfolio approach practical expedient An entity may apply the guidance in ASC 606 to a portfolio of contracts (or performance obligations) with similar characteristics if the entity reasonably expects that the effects on the financial statements would not differ materially. Quantitative assessment not required! Grant Thornton LLP. All rights reserved. 25

Contract combinations Single objective Dependent consideration Combine contracts Single performance obligation Entered into at or near the same time Same customer (or related parties) 2016 AICPA SEC and PCAOB Current Developments Conference SEC Staff view: Contracts that are not with the same customer or related parties do not meet the contract combination guidance in ASC 606, even if all other criteria are met. Grant Thornton LLP. All rights reserved. 26

Step 1 takeaways MSAs might not pass Step 1 No more cash-basis accounting Collectibility vs. price concession determination will be challenging There is a new way of thinking about collectibility Grant Thornton LLP. All rights reserved. 27

Five-step model Identify the contract with a customer Identify the performance obligations Determine the transaction price Allocate the transaction price to the performance obligations Recognize revenue when or as an entity satisfies performance obligations Grant Thornton LLP. All rights reserved. 28

Identify promised goods and services May not be limited to explicit goods/services Identify promises Includes implied promises Does not include activities that the entity must undertake to fulfill a contract that do not transfer a good or service (administrative tasks, setup activities) Not required to assess promises that are immaterial in the context of the contract Grant Thornton LLP. All rights reserved. 30

Example Promises must transfer goods or services to the customer Background: A software-as-a-service (SaaS) provider enters into a one-year contract with a customer to give access to the provider's services through the customer's platform. The SaaS provider must perform set-up and activation activities in order for its customer to receive the contracted SaaS services from the provider. What are the promises in the contract? Grant Thornton LLP. All rights reserved. 31

Performance obligation A performance obligation is a promise to transfer either: a) A distinct good or service b) A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer Capable of being distinct Distinct within the context of the contract Distinct (Identify as a separate performance obligation) Can benefit from the good or service on its own or with other "readily available resources" Is the nature of the promise to transfer each good or service or a combined item? 1. Significant integration service 2. One good/service significantly modifies/customizes another 3. Highly interdependent or highly interrelated Grant Thornton LLP. All rights reserved. 32

Example Focusing on "capable of being distinct" Entity A contracts with a customer to sell equipment and installation services. The installation is not complex and is offered by several other providers; however, the contract requires the customer to use Entity A's installation services. Promises Equipment Capable of being distinct? Distinct within the context of the contract? Distinct = Separate PO? Entity A identifies two promises (1. equipment and 2. installation). Installation Are the promises distinct, meaning should the entity identify the promises as separate performance obligations? Grant Thornton LLP. All rights reserved. 33

Example Focusing on "distinct in the context of the contract" An event planner enters into a contract to coordinate a company holiday party for a customer. The event planner is responsible for the overall management of the party, which includes: Promises Venue Capable of being distinct? Distinct within the context of the contract? Procuring a venue Arranging for food and drink refreshment to be provided Refreshment Entertainment Providing entertainment Staffing the event Staff Grant Thornton LLP. All rights reserved. 34

Stand-ready obligations Providing a service of standing ready to provide goods or services or making a good or service available for a customer to use as and when the customer decides Type A Type B Type C Type D Delivery is within the control of the entity, but the good, service, or IP must be further developed Delivery is outside of the control of the entity and customer Delivery is within the control of the customer Making a good or service available to the customer continuously Software updates Snow removal Periodic maintenance Health club membership Grant Thornton LLP. All rights reserved. 35

Stand-ready obligations Is the nature of the good or service underlying the promises the act of "standing ready" or the actual delivery of the underlying goods or services that the entity stands ready to provide? Consider whether the obligation is to provide a defined good or service, or instead, to provide an unknown type or quantity of goods or services When-and-if updates or upgrades may require additional analysis How should an entity measure progress of the stand-ready obligation that is satisfied over time? It depends Do not default to straight-line revenue recognition Grant Thornton LLP. All rights reserved. 36

Warranties Does the customer have the option to separately purchase a warranty? N Does all or part of the warranty provide the customer with an additional service beyond the assurance that the product will comply with agreed-upon specifications? N Account for the warranty using the cost accrual guidance Y Y Account for the warranty as a performance obligation Account for the service as a performance obligation One contract could include multiple types of warranties Grant Thornton LLP. All rights reserved. 37

Example Warranties AutoCo sells a vehicle to a customer with a standard bumper-to-bumper auto warranty Lasts for 2 years or 24,000 miles Includes 2 oil changes per year The entity identifies the following performance obligations: Vehicle Oil changes Grant Thornton LLP. All rights reserved. 38

Series of distinct goods and services Would each distinct good/service meet the criteria to be a performance obligation satisfied over time? Would the entity measure progress using the same measure for each distinct good or service? Y Identify the entire series as a single performance obligation NOT optional Y N N Series guidance does not apply Grant Thornton LLP. All rights reserved. 39

Example Series guidance Satisfied over time Same measure of progress Single performance obligation Customer simultaneously receives and consumes the benefits of the cleaning services Same measure of progress (each day of cleaning) The entity identifies the series of distinct cleaning services as a single performance obligation Grant Thornton LLP. All rights reserved. 40

Example Series guidance continued A software company hosts a platform for its customers to access a database of current statistics and player information for a variety of athletic teams. The company provides the customer with continuous access to its system which it uses to print standard reports. The customer pays an annual fee plus a fee per report. Does the service meet the definition of a series? Yes, the nature of the promise is to provide continuous access to the up-to-date information. Each day of access meets the criteria to be satisfied over time and the measure of progress for each day would be the same. Grant Thornton LLP. All rights reserved. 41

Step 2 takeaways Identifying performance obligations is key Consider stand-ready obligations Look closely at warranty terms Don't forget about the series guidance Grant Thornton LLP. All rights reserved. 42

Accounting for options For example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographic area or market N Does the option provide the customer with a material right that it would not receive without entering into the contract? Y Account for the option as a marketing or promotional offer not a performance obligation Account for the option as a performance obligation Grant Thornton LLP. All rights reserved. 45

Example Option to acquire additional goods/services Background: An athletic team sells season tickets which include an option to purchase additional event tickets at a 20% discount. The additional events typically sell out. No discount is provided to the general public. Does the option provide the customer with a material right? Yes, because the discount is incremental to the discount available to all customers. Grant Thornton LLP. All rights reserved. 46

Non-refundable upfront fees Joining fees Activation fees Set-up fees Provide the customer with an option for additional goods or services that gives rise to a material right? For goods or services provided at contract inception? Grant Thornton LLP. All rights reserved. 47

Example Cable activation fees Background: An cable provider enters into a contract to provide cable services for a period of 24 months for $100 per month. The contract includes and upfront activation fee of $75. Activation does not require the installation of any equipment or any other activity on behalf of the cable provider beyond flipping a switch. The customer may cancel at any time without paying a termination penalty. Does the upfront fee relate to activities that represent a distinct performance obligation? No, the fee is an advance payment for future goods or services. Over what period should the fee be recognized? Depends does the fee provide a material right? Grant Thornton LLP. All rights reserved. 48

Considerations Factors Non-refundable upfront fees Renewal price vs. new customer price Available alternatives Average customer life Renewal of $100 per month compared to new customer price of $175 ($100 monthly service + $75 activation fee) Consider availability and pricing of service alternatives Average customer life that extends well beyond the one-month contractual period is an indication that the fee incentivizes continued service Grant Thornton LLP. All rights reserved. 49

Finishing strong in the ASC 606 marathon webcast series Part 1 An in-depth look at designing for success Part 2 Steps 1 and 2 of the new revenue model Part 3 - Steps 3 and 4 of the new revenue model May 10, 2017 1-2:30 p.m. CT 1.5 CPE hours Part 4 - Step 5 and contract costs May 23, 2017 1-2:30 p.m. CT 1.5 CPE hours Part 5 - Licensing, modifications, and other potential hurdles June 13, 2017 1-2:30 p.m. CT 1.5 CPE hours To register for one or all of the webcasts, please visit www.grantthornton.com/events Grant Thornton LLP. All rights reserved. 51

Disclaimer This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered. For additional information on matters covered in this presentation, contact your Grant Thornton, LLP adviser. Grant Thornton LLP. All rights reserved. 53

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