Issues & Trends Defining Issues February 2013, No. 13-8 Revenue Recognition: Boards Decide Scope and Industry-Specific Issues At their January 2013 meeting, the FASB and IASB (the Boards) made tentative decisions about the scope of their revenue recognition project, application of the proposed standard to sales of nonfinancial assets that are not an output of a vendor s ordinary activities, application to certain asset management contracts, and accounting for certain repurchase agreements. The Boards also discussed feedback on the proposed disclosure and transition provisions, but made no decisions. The Boards tentatively decided: To confirm the scope of their November 2011 revised joint exposure drafts on revenue recognition (2011 EDs), including the definition of a customer. 1 In addition, the Boards provided clarifications on the application of the proposed standard to collaborative arrangements and financial services contracts. To confirm that the control and measurement (including the constraint) provisions of the proposed standard would apply to sales of nonfinancial assets that are not an output of a vendor s ordinary activities. In addition, the Boards tentatively decided that a vendor should apply the existence of contract provisions for those sales of nonfinancial assets transactions. Contents Scope 2 Sale of Assets That Are Not Part of a Vendor s Ordinary Activities 4 Asset Management Contracts 5 Repurchase Agreements 6 Disclosure and Transition Feedback 9 Interaction with FASB s Financial Instruments Impairment Project 9 Updated Redeliberations Plan 11 Summary of Joint Tentative Decisions on Revenue Recognition 12 To revise and clarify certain aspects of the proposed implementation guidance on repurchase agreements from their 2011 EDs, including adopting changes to conform that guidance to tentative decisions on sale-leaseback accounting reached by the Boards on their joint leases project. 2 To confirm that an asset manager s performance-based incentive fees should be subject to the revenue constraint. The FASB also tentatively decided to retain existing U.S. GAAP guidance on asset managers accounting for upfront commission costs for mutual funds that have a back-end sales charge. This edition of Defining Issues summarizes these tentative decisions and other discussions. In addition, this edition summarizes the interaction of the revenue proposal with the recent proposed Accounting Standards Update (ASU) on accounting for credit impairment losses on financial assets. 3 For a podcast summary of this Defining Issues go to: http://www.kpmginstitutes.com/financial-reporting-network/events/boards-decidescope-certain-industry-specific-issues.aspx. 1 FASB Proposed Accounting Standards Update, Revenue from Contracts with Customers, November 14, 2011, available at www.fasb.org, and IASB ED/2011/6, Revenue from Contracts with Customers, November 2011, available at www.ifrs.org. 2 Refer to the summary of Leases Joint Project of the FASB and IASB, available at www.fasb.org. Also see KPMG s Defining Issues publications on the Boards redeliberations of their joint leases project, all available at www.kpmginstitutes.com/financial-reporting-network. 3 FASB Proposed Accounting Standards Update, Financial Instruments Credit Losses, December 20, 2012, available at www.fasb.org.
Scope 2011 EDs Guidance Collaborative Arrangements. The Boards excluded from the scope of the proposed standard contracts with a collaborator or a partner that are not customers but rather merely share with the vendor the risks and benefits of developing a product to be marketed. The Boards defined a customer as a party that has contracted with a vendor to obtain goods or services that are an output of the vendor s ordinary activities and noted that all facts and circumstances should be considered in determining whether the counterparty is a customer. Financial Services Contracts. The 2011 EDs scoped out certain contracts such as financial instruments. However, they also specified that a contract with a customer may be partially in the scope of the revenue recognition guidance and partially in the scope of other accounting guidance (e.g., a contract with a lease of an asset and services). If the other accounting guidance specifies how to separate and/or initially measure one or more parts of a contract, then a vendor would first apply those requirements. Otherwise, the vendor would apply the revenue recognition guidance to separate or initially measure the separately identified parts of the contract. Collaborative Arrangements. A few respondents to the 2011 EDs questioned whether a transaction with a collaborator or partner could ever be within the scope of the proposed revenue model. Others asked whether the Boards had intentionally limited collaborative arrangements to projects aimed at developing a marketable product. A few respondents requested further guidance on distinguishing a customer from a collaborator. Finally, a few respondents questioned whether the proposed revenue guidance could be applied by analogy to transactions outside the scope of the proposed standard. At their January 2013 meeting, the Boards confirmed the scope of the proposed standard including the definition of a customer ( a party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities ). The Boards tentatively decided to clarify that: A collaborative arrangement is not limited to the development and commercialization of a product. A contract with a collaborator or a partner is within the scope of the revenue standard if the counterparty meets the definition of a customer. KPMG Observations It will be important for a vendor that engages in collaborative arrangements to analyze whether the other collaborators are customers and, thus, lead to revenue generating activities. For example, a biotech entity may conclude that a collaborative arrangement with a pharmaceutical entity to provide a license to a drug candidate and ongoing research and development services includes a revenue contract that is in the scope of the proposed standard because the pharmaceutical entity is a customer that receives the license and services as part of the biotech entity s ordinary activities. The Boards also observed that a Defining Issues / February 2013 / No. 13-8 2
vendor should evaluate the relationship with the counterparty throughout the duration of the contract. For example, the counterparty may be a collaborator for certain parts of the contract and a customer for other parts of the contract. Current U.S. GAAP provides income statement presentation guidance with respect to a collaborative arrangement, which is defined as an arrangement that meets the following two criteria: (a) the parties are active participants in the arrangement, and (b) the participants are exposed to significant risks and rewards that depend on the endeavor's ultimate commercial success. 4 It is our understanding that this guidance would not be superseded by the proposed standard. However, that guidance does not address recognition and measurement of collaborative arrangements. Because the Boards have explicitly excluded collaborative arrangements with parties that are not customers from the scope of the proposed standard, we believe that a vendor would continue to account for those arrangements based on its current accounting policy. It is our understanding that the Boards decision on collaborative arrangements is consistent with the current definition and application of collaborative arrangements in ASC Topic 808. Financial Services Contracts. Some comment letter respondents requested clarification on the accounting for financial services contracts that are partially within the scope of the proposed standard and partially within the scope of other standards. For example, one respondent noted that treasury services provided by banks such as lock box, check clearing, and account reconciliations provided at reduced rates or with no charge (based on customer deposits) would not be affected by the proposed revenue standard because the accounting for customer deposits would not change. At their January 2013 meeting, the Boards tentatively decided to clarify how a vendor would apply the proposed revenue standard when a contract with a customer is partially within its scope and partially within the scope of other standards such as financial services contracts. The Boards observed that a vendor would: First apply the financial instruments guidance for determining which parts of a financial services contract are separated and excluded from the proposed revenue standard, and Then ascribe the residual amount to components within the revenue standard. The Boards also observed that there may be immaterial or no amounts left to allocate to components of a financial services contract that fall within the 2011 EDs scope. KPMG Observations The Boards tentative decision clarifies that for a financial services contract, a vendor would first apply other standards and then the proposed revenue standard. For example, assume a bank has a contract with a customer that provides the customer with a loan at a below market interest rate and investment banking services for a fixed fee. If the bank did not elect the fair value option for the loan, then it would be recognized at its amortized cost (less 4 FASB ASC Subtopic 808-10, Collaborative Arrangements Overall, available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 3
impairment) and the investment banking services would be recognized at the fixed fee in the contract. Thus, no additional amount would be allocated to the loan even though the loan had a below market interest rate. This accounting is consistent with the current requirements for recognition of a premium or discount on receivables and payables, which do not apply to the customary cash-lending activities and demand or savings deposit activities of financial institutions whose primary business is lending money. 5 Similarly, there is no change from current practice for accounting for cash deposits with free treasury services because the amount received for the cash deposit would be recognized as a deposit liability with no amounts allocable to the free treasury services. Sale of Assets That Are Not Part of a Vendor s Ordinary Activities 2011 EDs Guidance Certain aspects of the 2011 EDs would be applied to sales of intangible assets, real estate, and other property, plant, and equipment that are not an output of the vendor s ordinary activities. A vendor would derecognize the asset when the counterparty obtains control of the asset. The resulting gain or loss would be based on the difference between the transaction price and the carrying amount of the asset, but limited to amounts to which the seller is reasonably assured to be entitled. Respondents generally agreed with the 2011 EDs proposals. However, some respondents expressed concern with the potential accounting outcome from applying the constraint on variable consideration to the sale of nonfinancial assets, which could result in a Day 1 loss when the nonfinancial asset is derecognized because of the inability to recognize the contingent payments until subsequent periods. Those respondents generally would prefer that the consideration received from a sale of a nonfinancial asset be measured at fair value. At their January 2013 meeting, the Boards tentatively decided to confirm the consequential amendments proposed in the 2011 EDs that a vendor would apply the control and measurement requirements (including the constraint) to determine when the asset should be derecognized and the amount of consideration to be included in measuring the gain or loss recognized on transfer. In addition, the Boards tentatively decided that the requirements for determining whether a contract exists should apply to transfers of nonfinancial assets that are not an output of an entity s ordinary activities. KPMG Observations The proposed guidance would apply to sales of intangible assets and property, plant, and equipment, including real estate, that are not an output of the vendor s ordinary activities and transfers of a financial asset that are insubstance real estate. An exchange of a group of assets that constitutes a business or nonprofit activity (except for a transfer of in-substance real estate and conveyance of oil and mineral rights) would continue to be accounted for 5 FASB ASC Subtopic 835-30, Interest Imputation of Interest, available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 4
using current consolidation guidance. 6 Currently, vendors would first be required to determine whether or not a group of nonfinancial assets being transferred constitutes a business. If the group of nonfinancial assets does not constitute a business, a vendor then would be required to apply the proposed standard. Asset Management Contracts 2011 EDs Guidance Performance-based incentive fees in asset management contracts would be subject to the revenue constraint because they represent a form of variable consideration. Example 13, Management Fees, included in the implementation guidance to the 2011 EDs indicates that because these performance-based incentive fees are significantly affected by factors outside the asset manager s influence (e.g., fluctuations in the stock market), an asset manager s previous experience with similar contracts would not be predictive of the amount of consideration to which it would be entitled under the contract. Therefore, the asset manager would not be reasonably assured to be entitled to the performance-based incentive fees until the end of the applicable measurement period. Accounting for Performance-Based Incentive Fees. The majority of industry respondents agreed with the proposed model. However, those respondents believe that the Boards should clarify Example 13, Management Fees, in the 2011 EDs implementation guidance to indicate that some performance-based asset management fees may meet the reasonably assured threshold prior to the end of the measurement period. A few respondents said that investment advisors should be permitted to recognize performance fees in interim periods in which the investment manager s performance exceeds the specified performance targets even if the determination of the performance fees is not finalized until a later period. At their January 2013 meeting, the Boards decided to confirm that an asset manager s performance-based incentive fees would be subject to the revenue constraint and the recognition of these fees would be limited to amounts for which external factors (e.g., market volatility) do not create a risk of a significant revenue reversal. KPMG Observations Some Board members observed that although Method 2 in current U.S. GAAP (i.e., recognize revenue each period at the amount the asset manager would earn if the end of the reporting period were the end of the contract period) provides a good depiction of an asset manager s performance each period, it is not consistent with the objective of the constraint, which is to recognize revenue at an amount that is not subject to a risk of significant revenue reversal. 7 6 FASB ASC Subtopic 810-10, Consolidation Overall, available at www.fasb.org. 7 FASB ASC Section 605-20-S99 (formerly EITF Topic No. D-96, Accounting for Management Fees Based on a Formula), Revenue Recognition Services SEC Materials, available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 5
The Boards observed that the proposed standard also is different from Method 1 in current U.S. GAAP because an asset manager is not precluded from recognizing a portion of the performance-based incentive fee prior to the resolution of the contingency if the amount to be recognized is not subject to a risk of significant revenue reversal. For example, if the asset manager locks in the performance fee prior to the end of the contract period by diverting the managed funds to money market investments and intends to hold the managed funds in money market investments until the end of the contract period, the asset manager might be able to recognize a portion of the performance fees prior to the end of the contract period. Accounting for Upfront Commission Costs. Current U.S. GAAP allows asset managers to defer and amortize commissions paid upfront to third-party brokers who distribute fund shares to investors. 8 Some respondents to the 2011 EDs questioned why the FASB proposed to remove this industry-specific cost guidance. Those respondents view the costs as fulfillment costs of the asset manager s distribution service obligation to the fund, rather than customer acquisition costs, because the investors to whom the shares are distributed are not the asset manager s customers. At the January 2013 meeting, the FASB tentatively decided to retain the specific cost guidance for investment companies, which would allow asset managers to continue to defer and amortize upfront commission costs consistent with current practice. Repurchase Agreements 2011 EDs Guidance If a vendor sells an asset to a customer and unconditionally promises to repurchase the asset, the accounting depends on the form of the promise (i.e., forward, call option, or put option). If a customer has a significant economic incentive to exercise an unconditional right to require the vendor to repurchase the asset (put option), the customer would be considered to effectively pay the vendor for the right to use the asset for a period of time. Consequently, the vendor would account for the agreement as a lease. To determine whether the customer has a significant economic incentive to exercise its right, a vendor would consider factors including the relationship of the repurchase price to the expected market value of the asset at the date the repurchase option is exercisable and the amount of time until the right expires. The 2011 EDs specify that if the repurchase price is expected to exceed the market value of the asset, the customer would have a significant economic incentive to exercise the put option. If the customer does not have a significant economic incentive to exercise its right, the vendor would account for the agreement similar to a sale of a product with a right of return. If the vendor has an unconditional obligation (a forward) or an unconditional right (a call option) to repurchase the asset, the customer would not have control of the asset. The vendor would account for the agreement as a lease if it expects 8 FASB ASC paragraph 946-605-25-8 (formerly EITF Issue No. 85-24, Distribution Fees by Distributors of Mutual Funds That Do Not Have a Front-End Sales Charge), available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 6
to repurchase the asset for less than the original sales price of the asset. If the vendor expects to repurchase the asset for an amount that is greater than or equal to the original sales price, it would account for the transaction as a financing arrangement. Some respondents to the 2011 EDs questioned why the proposed guidance on repurchase agreements is limited to only unconditional repurchase options, which excludes repurchase agreements that may have conditions but are otherwise economically similar. Other respondents requested clarification on whether processing costs should be included in the repurchase price of a product financing arrangement when a vendor sells a product to a contract manufacturer and then repurchases the product or processed goods of which the original product is a component. Respondents from the automotive industry expressed the following concerns on the proposed guidance for repurchase agreements. Existing U.S. GAAP requires that contracts that include minimum residual value guarantees be accounted for as leases, irrespective of whether the customer has to return the asset to the vendor. 9 Some respondents noted that the proposed standard may lead to different accounting for economically similar transactions (e.g., the automaker that sells to a rental company and agrees to repurchase the auto after a specified time period would account for that transaction differently from an agreement to provide a guarantee of the minimum resale value for that auto) and may provide structuring opportunities. Current guidance on products sold to a dealer by a manufacturer specifies that when certain conditions are met, the manufacturer recognizes a sale of the product to the dealer even when the manufacturer or its financing affiliate has agreed to repurchase the auto from the dealer to provide an operating lease to 10 the dealer s retail customer. Automakers pointed out that the current guidance would be eliminated by the proposed standard and, therefore, the Boards should clarify how they would expect automakers to account for these transactions. At their January 2013 meeting, the Boards tentatively decided: To remove the word unconditional from the implementation guidance for repurchase agreements. To clarify that in a product financing arrangement (i.e., when a vendor sells a product to another entity and repurchases that product as part of a larger component for a higher price), the vendor would exclude the processing costs from the repurchase price in determining the amount of interest related to the financing component of the arrangement. That no amendments to the guidance were necessary for the sale of a good to a customer with a guarantee that the customer will receive a minimum resale 9 FASB ASC paragraphs 840-10-55-12 through 25 (formerly EITF Issue No. 95-1, Revenue Recognition on Sales with a Guaranteed Minimum Resale Value), available at www.fasb.org. 10 FASB ASC paragraph 605-15-25-5 (formerly EITF Issue No. 95-4, Revenue Recognition on Equipment Sold and Subsequently Repurchased Subject to an Operating Lease), available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 7
amount because the Boards confirmed that the existence of the guarantee would not preclude the transfer of control of the product to the customer. That no amendments to the guidance were necessary for the sale of a good to a customer that is subsequently repurchased by the vendor for the purpose of leasing it to the customer s customer. The Boards confirmed that the repurchase of the good by the vendor subsequent to the customer obtaining control of that good does not constitute a repurchase agreement as described in the proposed revenue standard. However, in determining whether the customer obtained control of the good, a vendor should consider the principal versus agent guidance. That a sale-leaseback transaction that includes a put option with a repurchase price that is less than the original sales price and for which the customer has a significant economic incentive to exercise would be accounted for as a financing arrangement because the customer (buyer-lessor) would not be deemed to obtain control over the asset subject to the sale-leaseback transaction. KPMG Observations Removal of the Word Unconditional. The Boards tentative decision to remove the word unconditional would result in the proposed guidance being more consistent with current real estate guidance. For example, if a vendor has an option to repurchase the property from the buyer, or the buyer has an option to require the seller to repurchase the property if the value of the property appreciates above a specific market threshold (which is a price higher than the original sales price), and it is likely that the value of the property will appreciate above the specific threshold, the vendor would account for the transaction as a financing arrangement. Processing Costs. The Boards tentative decision would result in guidance that is consistent with current guidance on product financing arrangements. 11 The Boards acknowledged that a financing arrangement also may include processing by the buyer. For example, an automaker may sell steel to a parts supplier and in a related transaction agree to purchase component parts from the supplier containing a similar amount of steel. The price of the component parts includes processing, holding, and financing costs. The vendor should separately identify the processing costs from the financing and holding costs and record processing costs as part of the cost of the product. Guaranteed Minimum Resale Value. Some Board members observed that they believe there is a substantive difference between a contract that includes a customer put option where the customer has a significant economic incentive to exercise and a contract in which the automaker guarantees the auto s minimum resale value. In the former case, the customer does not control the asset because it has a significant economic incentive to put the auto back to the automaker. In the latter case, the customer can retain the auto or can sell it on its own terms, retaining any excess proceeds it may receive above the guaranteed minimum resale amount; therefore, the customer is deemed to control the asset (i.e., direct its use and obtain substantially all of its economic benefits). The Boards tentative decision with respect to contracts that include 11 FASB ASC Subtopic 470-40, Debt Product Financing Arrangements, available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 8
minimum resale value guarantees would result in a change from existing U.S. GAAP that some Board members believe is a consequence of a transfer of control model rather than a risks and rewards model. Equipment Sold and Subsequently Repurchased Subject to an Operating Lease. The Boards observed that contracts entered into by the vendor with parties in the distribution channel that are not customers of the vendor are not combined. For an automaker, the customer for the sale of the vehicle typically is the dealer while the customer for an operating lease agreement is the end user. Because the dealer and the end user are not related parties, those contracts (the initial sale of the vehicle to the dealer and the subsequent lease contract with the end user) would not be evaluated for combining purposes and would be treated as separate contracts. In a contract in which an automaker sells to a dealership and agrees to subsequently repurchase the auto if the dealer s customer chooses to lease it through the automaker s captive finance affiliate, the automaker would generally recognize revenue upon the sale of the auto to the dealership using the point in time transfer of control indicators in the 2011 EDs. The Boards discussed a transaction where the end consumer orders a customized auto with the automaker and concurrently enters into a finance agreement with the finance affiliate of the automaker. The Boards noted that the automaker should consider the principal versus agent guidance in the proposed standard in evaluating whether the dealer is acting as an agent for the automaker. Sale-Leaseback Transactions with Put Options. The Boards previously reached a tentative decision that the leaseback in a sale-leaseback transaction would not automatically preclude a seller from concluding that it had transferred control of the asset to the customer but that a sale-leaseback transaction not accounted for as a sale would be accounted for as a financing arrangement. The Boards tentative decision at their January 2013 meeting is intended to clarify when a seller-lessee has not transferred control to the buyer-lessor in a saleleaseback transaction as a result of a put option held by the buyer-lessor. Disclosure and Transition Feedback At their January 2013 meeting, the staff provided the Boards with a summary of the feedback received on the Boards proposed disclosure and transition requirements. This feedback was received through comment letters, outreach, and workshops held in Japan, the United Kingdom, and the United States that included both preparers and financial statement users. The Boards were not asked to make any decisions with respect to the feedback. Instead, the issues will be discussed by the Boards in February 2013. Interaction with FASB s Financial Instruments Impairment Project On December 20, 2012, the FASB issued a proposed ASU on credit losses that would change the way an entity recognizes credit impairment losses on financial assets. 12 The FASB s proposed impairment model would reflect a vendor s current 12 FASB Proposed Accounting Standards Update, Financial Instruments Credit Losses, available at www.fasb.org. Defining Issues / February 2013 / No. 13-8 9
estimate of contractual cash flows that are not expected to be collected in the determination of the credit loss. Receivables that result from revenue transactions (i.e., trade receivables) are included within the scope of the proposed ASU. However, contract assets reflecting revenue recognized in advance of contractual billings that are contingent on something other than the passage of time are not within its scope. KPMG Observations The proposed standard does not include collectibility as a recognition threshold that would require an assessment of the customer s ability to pay the promised amount of consideration before revenue could be recognized. Instead, a vendor would recognize revenue (even when collectibility is not probable or reasonably assured) and separately recognize an allowance for any expected credit impairment loss from contracts with customers following the guidance that applies to financial assets (trade receivables). As a result of the proposed removal of the collectibility threshold, revenue may be recognized earlier than under current U.S. GAAP for certain contracts with a corresponding credit impairment loss for a vendor s estimate of contractual cash flows that are not expected to be collected. The IASB is also expected to issue an exposure draft of its financial asset impairment model in the first quarter of 2013. Defining Issues / February 2013 / No. 13-8 10
Updated Redeliberations Plan The following table summarizes the remaining issues currently scheduled for redeliberations. The topics may change if deemed necessary by the Boards and their staff. The timing for discussion is undetermined. Issues to Be Redeliberated at Future Meetings Contract issues relating to whether a credit-card issuing bank should combine contracts with its cardholders who participate in its loyalty programs with merchant contracts and whether a contract with merchants should allocate a portion of the revenue generated from the merchant interchange fees to the goods or services provided under the loyalty programs. Disclosures: Consideration of the costs to prepare the proposed disclosures, including accessibility of the necessary information; Usefulness of the disclosures to financial statement users; Reconsideration of proposed interim reporting requirements; and Whether there are different needs of public and nonpublic financial statement users (FASB only). Transition, effective date, and early adoption: Consideration of the challenges and costs of retrospective application; Assessment of whether financial statement users needs for comparative financial information can be met through alternatives to full retrospective application; Determination of an effective date based on the transition method; and Consideration of early adoption. Remaining issues and consequential amendments, including: Licensing and rights to use intellectual property, if needed. Cost-benefit analysis. Defining Issues / February 2013 / No. 13-8 11
Summary of Joint Tentative Decisions on Revenue Recognition The following chart summarizes the changes made by the Boards to the 2011 EDs during redeliberations. All decisions are tentative until a final standard is issued. 2011 EDs Tentative Decisions Scope Definition of a Customer A party that has contracted with a vendor to obtain goods or services that are an output of the vendor s ordinary activities. Other parties to a contract may not be customers, but may be partners or collaborators with the vendor in developing goods or services to be sold to customers. In this situation, the guidance in the proposed standard would not apply. Contracts Partially in the Scope of Other Accounting Guidance A contract with a customer may be partially in the scope of the 2011 EDs and partially in the scope of other accounting guidance (e.g., a contract with a lease of an asset and services). If the other accounting guidance specifies how to separate and/or initially measure one or more parts of a contract, then a vendor would first apply those requirements. Otherwise, the vendor would apply the 2011 EDs to separate and/or initially measure the separately identified parts of the contract. Definition of a Customer The Boards have not revised the 2011 EDs scope, including the definition of a customer. The Boards tentatively decided to clarify that certain transactions with a collaborator or partner can be within the scope of the proposed revenue standard if the collaborator is a customer for certain transactions. The Boards also tentatively decided to clarify in the final standard that a collaborative arrangement is not limited to developing a commercial product to be marketed. Contracts Partially in the Scope of Other Accounting Guidance The Boards affirmed the 2011 EDs proposal that for arrangements partly in its scope and partly in the scope of another standard/topic, other standards/topics (e.g., financial instruments) should be applied first to allocate consideration to the components in the scope of the other standard/topic. Any residual consideration remaining after this allocation would become the transaction price allocable to the performance obligation(s) accounted for under the proposed revenue model. Step 1 Identify the Contract with the Customer Definition of a Contract A contract is an agreement between two or more parties that Definition of a Contract The Boards have not revised the 2011 EDs definition of a contract. Defining Issues / February 2013 / No. 13-8 12
creates enforceable rights and obligations. The 2011 ED specifies that enforceability is a matter of law. A contract exists if it has commercial substance (i.e., the risk, timing, or amount of the vendor s future cash flows is expected to change as a result of the contract); the contract is approved by all parties, and they are committed to fulfill their respective obligations; the vendor can identify each party s rights for the goods or services to be transferred; and the vendor can identify the payment terms for those goods or services. The Boards tentatively decided to provide additional guidance in the final standard on determining whether a contract with a customer exists based on the customer s commitment to perform its obligations under the contract. Step 2 Identify the Separate Performance Obligations in the Contract A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. Performance obligations include promises that are implied by a vendor s customary business practices, published policies, or specific statements if those promises create a valid expectation of the customer that the vendor will transfer a good or service (e.g., customer loyalty programs). Certain conditions must be met for a performance obligation to be considered a separate performance obligation and accounted for as its own unit of account within the contract. The Boards have not revised the definition of a performance obligation from the one included in the 2011 EDs. However, the Boards tentatively decided that a promise to transfer goods or services to an unrelated party (i.e., the customer s customer) as a sales incentive that was made in the contract or implied by a vendor s customary business practices, published policies, or specific statements, would be treated as a performance obligation in the transaction with the customer. If the promise was made after the transfer of control of the product to the intermediary, the Boards affirmed that the promise would not be treated as a performance obligation. Criteria for Identifying Separate Performance Obligations A single contract may have promises to deliver more than one good or service. A vendor would Criteria for Identifying Separate Performance Obligations A single contract may have promises to deliver more than one good or service. A vendor would Defining Issues / February 2013 / No. 13-8 13
need to evaluate the promised goods or services to determine whether each good or service (or a bundle of goods or services) constitutes a separate performance obligation. A vendor would account for a promised good or service as a separate performance obligation only if it is distinct from other goods or services in the contract. A promised good or service would be distinct if both of the following are met: The vendor regularly sells the good or service separately; and The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. Readily available resources are goods or services that are sold separately (by the vendor or by another vendor) or resources that the customer already has obtained (from the vendor or from other transactions or events). Notwithstanding the above requirements, a good or service in a bundle of promised goods or services is not distinct, and should be accounted for as a single performance obligation, if both: The goods or services are highly interrelated and transferring them to the customer requires the vendor to provide a significant service of integrating the goods or services into the combined item for which the customer has contracted; and need to evaluate the promised goods or services to determine whether each good or service (or bundle of goods or services) constitutes a separate performance obligation. A vendor would account for a promised good or service as a separate performance obligation only if: The good or service is capable of being distinct because the customer can benefit from the good or service on its own (i.e., the good or service is an asset that on its own can be used, consumed, sold for an amount other than scrap value, held, or otherwise used in a way that generates economic benefits) or together with other resources that are readily available to the customer. Readily available resources are goods or services that are sold separately (by the vendor or by another vendor) or resources that the customer already has obtained from the vendor or from other transactions or events; and The good or service is distinct within the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract. The following indicators would be used to evaluate whether a good or service is distinct in the context of the contract: The vendor does not provide a significant service of integrating the bundle of goods or services. This means Defining Issues / February 2013 / No. 13-8 14
The bundle of goods or services is significantly modified or customized to fulfill the contract. The 2011 EDs guidance would allow vendors, as a practical expedient, to account for two or more distinct promised goods or services as a single performance obligation if those promised goods or services have the same pattern of transfer to the customer. that the vendor is not using the good or service as an input to produce the output specified in the contract; The customer was able to purchase, or not purchase, the good or service without significantly affecting the other promised goods or services in the contract; The good or service does not significantly modify or customize another good or service promised in the contract; and The good or service is not a part of a series of consecutively delivered goods or services promised in the contract that meets both of the following conditions: Those goods or services transfer to the customer over time (based on an evaluation under the performance obligation satisfied over time criteria); and The vendor uses the same method for measuring progress to depict the transfer of those goods or services to the customer. Step 3 Determine the Transaction Price Time Value of Money Time value is reflected in a vendor s estimate of the transaction price if the contract has a financing component that is significant to the contract using the discount rate that would be reflected in a separate financing transaction between the vendor and the customer at the inception The Boards tentatively decided to affirm the 2011 EDs proposed requirements that an entity should adjust the amount of promised consideration for the effects of the time value of money if the contract with a customer has a significant financing component. The Boards also tentatively decided: Defining Issues / February 2013 / No. 13-8 15
of the contract. To assess whether a financing component is significant to a contract, a vendor should consider all relevant factors including: The expected length of time between when the vendor transfers the promised goods or services to the customer and when the customer pays for those goods or services; Whether the amount of consideration would substantially differ if the customer paid in cash promptly under the typical credit terms in the industry and jurisdiction; and The interest rate in the contract and prevailing interest rates in the relevant market. The financing component would be recognized as interest expense (when the customer pays in advance) or interest income (when the customer pays in arrears). As a practical expedient, a vendor would not be required to reflect the time value of money in its estimate of the transaction price if the vendor expects at contract inception that the period between customer payment and the transfer of the promised goods or services to the customer will be one year or less. To clarify the application of the indicators in the 2011 EDs for determining whether a contract has a significant financing component; To clarify that if the transfer of goods or services to a customer is at the discretion of the customer, a vendor should not adjust advance payments for the effects of the time value of money; To retain the proposed practical expedient and clarify that the practical expedient also would apply to contracts with a duration of greater than one year if the period between performance and payment for that performance is one year or less; and To clarify that the proposed revenue standard would not preclude a vendor from presenting as revenue interest income that is recognized from contracts with a significant financing component. Step 3 Determine the Transaction Price Collectibility A vendor should not reflect the effects of a customer s credit risk in the measurement of the transaction price. Consequently, a vendor recognizes revenue at the promised amount of consideration (the amount to which a vendor The Boards tentatively decided that impairments from expected credit losses (i.e., bad debt expense) should be presented as a separate line item within operating expenses in the statement of comprehensive income, if that Defining Issues / February 2013 / No. 13-8 16
expects to be entitled in exchange for transferring promised goods or services). In addition, the proposed guidance does not include collectibility as a recognition threshold that would require an assessment of the customer s ability to pay the promised amount of consideration for revenue to be recognized. Impairments for expected credit losses (i.e., bad debt expense) would be presented as a separate line item adjacent to the revenue line item. In exceptional cases, if there is significant uncertainty about collectibility at contract inception, that uncertainty may indicate that the parties are not committed to perform their respective obligations and therefore, do not have a contract as defined in the proposed standard. The use of the installment and cost-recovery methods would be eliminated by the proposed standard. amount is material. This presentation requirement would apply to all credit loss impairments, whether determined at contract inception or subsequently. In reaching those tentative decisions, the Boards also tentatively decided to reaffirm the following proposals from the 2011 EDs relating to collectibility: A vendor should not reflect the effects of a customer s credit risk in the measurement of the transaction price; and An assessment of the customer s ability to pay the promised amount of consideration should not be required to recognize revenue (i.e., there should not be a collectibility threshold in the proposed standard). The Boards noted that if there is significant uncertainty about collectibility at contract inception, that may indicate that the parties are not committed to perform their respective obligations, and no contract exists. Step 4 Allocate the Transaction Price to the Separate Performance Obligations Relative Standalone Selling Price Method Relative Standalone Selling Price Method Under the proposed guidance, a vendor would allocate the transaction price to all separate performance obligations in proportion to the standalone selling price of the promised goods or services, except as noted below. No significant changes were made to the proposals in the 2011 EDs. The best evidence of standalone selling price would be the observable price for which the vendor sells the goods or services separately. In the absence of Defining Issues / February 2013 / No. 13-8 17
separate observable sales, the standalone selling price would be estimated. Reallocation of the transaction price for changes in standalone selling prices would not be allowed. The contingent revenue concept does not exist in the proposed revenue model. A vendor would recognize a contract asset for rights to consideration in exchange for goods or services that the vendor has transferred, even if that amount is contingent on future performance by the vendor. Determining a Standalone Selling Price The proposed standard would require a vendor to consider all information that is reasonably available and maximize observable inputs when estimating the standalone selling price. Estimation methods include, but are not limited to (a) adjusted market assessment approach, (b) expected cost plus a margin approach, and (c) residual approach. The residual approach would be appropriate only if the standalone selling price of a good or service is highly variable or uncertain and the standalone selling prices of the other performance obligations in the contract are observable. Determining a Standalone Selling Price The Boards tentatively decided to retain from the 2011 EDs the residual approach, adjusted market assessment approach, and expected cost plus a margin approach to estimating selling prices. The Boards clarified that the residual approach also could be used when two or more performance obligations in a contract have standalone selling prices that are highly variable or uncertain and at least one of the other goods or services in the contract has a standalone selling price that is not highly variable or uncertain. When there are two or more goods or services with highly variable or uncertain standalone selling prices, the Boards clarified that a vendor could use a combination of techniques to estimate their standalone selling prices by: First applying the residual approach to estimate the aggregate of the standalone selling prices for all of the goods or services with highly Defining Issues / February 2013 / No. 13-8 18
variable or uncertain standalone selling prices; and Using another technique to estimate the individual standalone selling prices relative to the aggregate standalone selling price estimated above. Allocating Discounts to One or Some Performance Obligations If the sum of the standalone selling prices exceeds the transaction price (i.e., the customer receives a discount for the bundle of goods), the discount would be allocated to all of the performance obligations unless both of the following criteria are met, in which case the entire discount would be allocated to the separate performance obligations to which the discount relates: Allocating Discounts to One or Some Performance Obligations The Boards clarified that discounts should first be allocated using the 2011 EDs guidance on allocating discounts to some performance obligations in the contract before using a residual approach to estimate the standalone selling price of any other performance obligations. The vendor regularly sells each good or service in the contract on a standalone basis; and The observable selling prices from those standalone sales provide evidence of the performance obligations to which the entire discount belongs. Allocation of Contingent Payments Entirely to a Distinct Good or Service If the transaction price includes consideration that is contingent on a future event or circumstance, the contingent amount would be allocated entirely to a distinct good or service only if both of the following criteria are met: The contingent payment terms for the distinct good or service relate specifically to the vendor s efforts to transfer Allocation of Contingent Payments Entirely to a Distinct Good or Service The Boards tentatively decided to retain the criteria from the 2011 EDs for determining when a vendor would allocate contingent consideration to distinct goods or services and clarified that a vendor could allocate contingent consideration to more than one distinct good or service in the contract. Defining Issues / February 2013 / No. 13-8 19
that good or service or to a specific outcome from transferring that good or service; and Allocating the contingent consideration entirely to the distinct good or service, when considering all of the performance obligations and payment terms in the contract, would depict the amount of consideration to which the vendor expects to be entitled for transferring that good or service. Step 5 Recognize Revenue Performance Obligations Satisfied Over Time A vendor transfers control of a good or service over time if at least one of the following two criteria is met: The Boards tentatively decided that a vendor transfers control of a good or service over time if one of the following criteria is met: The vendor s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or The vendor s performance does not create an asset with an alternative use to the vendor and at least one of the following criteria is met (1) the customer simultaneously receives and consumes the benefits as the vendor performs; (2) another vendor would not need to substantially reperform work the vendor has completed to date if that other vendor were to fulfill the remaining obligation to the customer; or (3) the vendor has a right to payment for performance completed to date and the vendor is expected to fulfill the contract as promised. The vendor s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; The customer receives and consumes the benefits as the vendor performs. A customer obtains the benefits of a vendor s performance if another vendor would not need to substantially reperform work the vendor has completed to date if that other vendor were to fulfill the remaining obligation to the customer; or The vendor s performance does not create an asset with an alternative use to the vendor, the vendor has a right to payment for performance completed to date, and it expects to fulfill the contract as promised. Defining Issues / February 2013 / No. 13-8 20