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Financial reporting developments The road to convergence: the revenue recognition proposal August 2010
To our clients and other friends
Financial reporting developments The road to convergence: the revenue recognition proposal
The Financial Accounting Standard Board (the FASB) and the International Accounting
Standards Board (the IASB) (collectively, the Boards) have jointly issued a proposed standard
to supersede virtually all existing revenue guidance under US GAAP and IFRS. Generally, the
Boards believe the new revenue model will accomplish the following:
► Remove the inconsistencies and weaknesses that currently exist in US GAAP
► Provide a framework for addressing revenue recognition issues
► Improve comparability of revenue recognition practices among industries, entities within
those industries, jurisdictions and capital markets
► Reduce the complexity of applying revenue recognition guidance by reducing the volume
of the relevant guidance
Revenue is defined under current US GAAP as ―inflows or other enhancements of assets of an
entity or settlements of its liabilities (or a combination of both) from delivering or producing
goods, rendering services or other activities that constitute the entity‘s ongoing major or
central operations.‖1 While this single definition of revenue exists, the authoritative guidance
for revenue recognition in the Accounting Standards Codification (ASC) was codified from
more than 200 individual pieces of literature issued by multiple standard setters. Most of the
existing US GAAP guidance is specific to certain transactions or certain industries, which has
resulted in numerous individual standards focused on very detailed matters. However, many
other topics within revenue recognition lack guidance or the existing guidance is unclear.
The proposed guidance specifies the accounting for all revenue arising from contracts with
customers and affects all entities that enter into contracts to provide goods or services to
their customers (unless those contracts are in the scope of other US GAAP requirements). In
addition, the existing requirements for the recognition of gains and losses on the sale of
certain nonfinancial assets, such as property and equipment, would be amended by the
proposed standard in order to be consistent with the measurement and recognition principles
in the proposed revenue model.
The proposed guidance outlines the principles that an entity would apply in order to report
decision-useful information regarding the measurement and timing of revenue and the
related cash flows. The core principle in the proposed standard is that an entity will recognize
revenue to depict the transfer of goods or services to customers at an amount that reflects
the consideration the entity expects to receive in exchange for those goods or services. The
principles in the proposed standard are applied using the following five steps:
1. Identify the contract(s) with a customer
2. Identify the separate performance obligations in the contract
3. Determine the transaction price
1 FASB Concepts Statement No. 6, Elements of Financial Statements (CON 6)
To our clients and other friends
To our clients and other friends
Financial reporting developments The road to convergence: the revenue recognition proposal
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue when the entity satisfies each performance obligation
An entity will be required to exercise judgment when considering the terms of the contract(s)
and all surrounding facts and circumstances, including implied contract terms, when applying
the proposed model. Further, an entity must apply the requirements of the proposed model
consistently to contracts with similar characteristics and in similar circumstances.
The Boards are proposing that companies adopt the new guidance retrospectively for all
periods presented in the period of adoption. The proposal does not include a proposed
effective date. Instead, the effective date will be considered as part of another project on the
effective dates for all of the major joint projects currently under way and expected to be
completed in 2011.
We have issued this publication to highlight some of the more significant implications of the
proposed revenue recognition model. In the coming weeks, we also will provide certain
industry-specific publications that will address, in further detail, the complexities and subtleties
that may give rise to significant changes to practice in those industries. We encourage
preparers and users of financial statements to read this publication and the forthcoming
supplements carefully and consider the potential effects of the proposed model on existing
revenue recognition practices. The issues discussed in this publication are intended to assist
companies in formulating feedback to the Boards that can help in the development of a high-
quality final standard. The discussions within this publication represent preliminary thoughts
and additional issues may be identified through continued analysis of the exposure draft (ED)
and as the elements of the ED change on further deliberation by the Boards.
The comment letter period ends on 22 October 2010 and the Boards also plan to hold public
roundtable meetings following the comment period to gather information and obtain the
views of interested parties about the proposed guidance. Interested parties should refer to
the ED on either of the Boards‘ websites for instructions on submitting comment letters and
registering for the roundtable events.
August 2010
Contents
Financial reporting developments The road to convergence: the revenue recognition proposal i
Chapter 1: Scope, transition and internal control considerations .................................... 1
1.1 Scope .......................................................................................................... 1 1.2 Transition .................................................................................................... 4 1.3 Internal control considerations ..................................................................... 4
Chapter 2: Identify the contract with the customer ........................................................ 6
2.1 Combination and segmentation of contracts .................................................. 8 2.2 Contract modifications ............................................................................... 11
Chapter 3: Identify the separate performance obligations in the contract .................... 14
3.1 Distinct goods and services ........................................................................ 15 3.2 Product warranties .................................................................................... 20
3.2.1 Quality assurance warranties ........................................................ 20
3.2.2 Insurance warranties .................................................................... 21
3.2.3 Differentiating between quality assurance and insurance warranties .................................................................................... 23
3.2.4 Combination warranties ................................................................ 23
3.2.5 Warranty costs ............................................................................. 25
3.3 Principal versus agent considerations ......................................................... 26 3.4 Consignment arrangements ....................................................................... 28 3.5 Customer options for additional goods ........................................................ 28 3.6 Sale of products with a right of return ......................................................... 31
Chapter 4: Determine the transaction price .................................................................. 33
4.1 Variable consideration ............................................................................... 34 4.2 Collectibility ............................................................................................... 38 4.3 Time value of money .................................................................................. 40 4.4 Noncash consideration ............................................................................... 42 4.5 Consideration paid or payable to a customer ............................................... 43 4.6 Nonrefundable upfront fees ........................................................................ 45
Chapter 5: Allocate the transaction price to the separate performance obligations ...... 48
5.1 Estimating standalone selling prices ............................................................ 49 5.2 Changes in transaction price subsequent to contract inception ..................... 53
Chapter 6: Satisfaction of performance obligations ...................................................... 55
6.1 Continuous transfer of goods and services .................................................. 57 6.2 Recognizing revenue when a right of return exists ....................................... 60 6.3 Repurchase agreements ............................................................................. 62
6.3.1 Written put option held by the customer ........................................ 62
6.3.2 Forward or call option held by the entity ........................................ 62
6.4 Licensing and rights to use ......................................................................... 64 6.5 Bill-and-hold arrangements ......................................................................... 66 6.6 Customer acceptance ................................................................................. 67
Contents
Contents
Financial reporting developments The road to convergence: the revenue recognition proposal
Chapter 7: Other measurement and recognition topics .................................................. 69
7.1 Onerous performance obligations................................................................ 69 7.2 Contract costs ............................................................................................ 72 7.3 Sale of nonfinancial assets .......................................................................... 74
Chapter 8: Presentation and disclosure ......................................................................... 76
8.1 Presentation — Contract assets and contract liabilities .................................. 76 8.2 Disclosure .................................................................................................. 76
8.2.1 Disaggregation of revenue ............................................................ 76
8.2.2 Reconciliation of contract balances ............................................... 77
8.2.3 Performance obligations ............................................................... 79
8.2.4 Onerous performance obligations .................................................. 80
8.3 Significant judgments in the application of the new standard ........................ 81
Chapter 1: Scope, transition and internal control considerations
Financial reporting developments The road to convergence: the revenue recognition proposal 1
1.1 Scope
The scope of the Boards‘ proposed guidance on revenue recognition includes all contracts
with customers to provide goods or services in the ordinary course of business. However, the
following contracts have been excluded from the scope of the proposed guidance:
► Lease contracts within the scope of Accounting Standards Codification (ASC) 8402 on
leases
► Insurance contracts within the scope of ASC 9443 on insurance
► Contractual rights or obligations (i.e., financial instruments) such as receivables, debt and
equity securities and derivatives4
► Guarantees (other than product warranties) within the scope of ASC 460, Guarantees
► Nonmonetary exchanges between entities in the same line of business to facilitate sales
to customers other than the parties to the exchange5
Entities will likely enter into transactions that are partially within the scope of the proposed
revenue recognition guidance and partially within the scope of other guidance. In their basis
for conclusions, the Boards noted that it would not be appropriate to account for such
contracts in their entirety under one standard or another. The Boards explain that different
accounting outcomes could result depending on whether the goods or services were sold on a
standalone basis or together with other goods and services. Under the proposed guidance, if
a contract is partially within the scope of the proposed revenue guidance and partially within
the scope of other guidance, entities would apply the separation and measurement
requirements of the other guidance first. If the other guidance does not specify how to
separate and initially measure any parts of the contract, the entity would apply the proposed
revenue recognition guidance to separate and initially measure those parts of the contract.
2 ASC 840, Leases 3 ASC 944, Financial Instruments — Insurance 4 This exclusion includes contracts within the scope of the following ASC Topics: ASC 310,
Receivables; ASC 320, Investments — Debt and Equity Securities; ASC 405-20, Extinguishments of
Liabilities; ASC 470, Debt; ASC 815, Derivatives and Hedging; ASC 825, Financial Instruments; and
ASC 860, Transfers and Servicing. 5 Refer to ASC 845, Nonmonetary Transactions
Chapter 1: Scope, transition and internal control considerations
Chapter 1: Scope, transition and internal control considerations
2 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
Entities entering into transactions that fall within the scope of multiple areas of accounting
guidance currently have to separate those transactions into the elements that are accounted
for under different pieces of literature. The ED does not propose to change this requirement,
nor does it change how the appropriate separation model is determined (e.g., which
accounting model is used to separate elements subject to different literature); therefore, we
do not expect a significant change in practice. However, under current US GAAP revenue
transactions are separated into elements that are accounted for under different pieces of
revenue guidance (e.g., a multiple-element transaction that falls within the scope of both the
multiple-element arrangements guidance in ASC 605-25 and the construction-type and
production-type arrangements guidance in ASC 605-35). Under the proposed guidance, this
separation would not be required as there would be a single revenue recognition model.
Interaction with the current joint project on leases
The Boards are currently working on a joint leasing project for which an ED was issued on
17 August 2010. In many respects, the proposed performance obligation and
derecognition models for lessor accounting within the expected leasing model are
consistent with the principles in the proposed revenue model. For example, the
requirement to continually assess the amounts of expected variable consideration is
consistent between the models. Another similarity includes the determination of whether
the risks or benefits have transferred to the lessee under the leasing model, which would
then require accounting under the derecognition model (i.e., similar to a sale). This
compares to the concept of transfer of control under the revenue model.
However, some aspects of the proposed leasing model are notably different from the
proposed revenue model. The most significant difference relates to the recognition of a
gross asset (for the right to receive future lease payments) and a gross liability (for the
obligation to permit the lessee to use the leased asset). Under the proposed revenue
model, contract assets and liabilities are not recorded at contract inception (i.e., they are
deemed to be equal and net to zero) and would only be recorded when one party to the
contract performs under the contract before the other party (see Section 8.1). Under
current US GAAP, revenue accounting and the accounting for leases by lessors is very
similar, particularly with respect to the recognition of assets and liabilities for leased assets
in operating leases. We believe that the proposed gross recognition of assets and liabilities
under the leasing model will require an increased emphasis on determining whether a
contract with a customer is a lease that is within the scope of the leasing guidance.
Chapter 1: Scope, transition and internal control considerations
Financial reporting developments The road to convergence: the revenue recognition proposal 3
Interaction with the current joint project on insurance contracts
The Boards are also deliberating6 a joint project on accounting for insurance contracts.
Based on the Boards‘ current views, we believe the concepts of the expected insurance
model are similar to the proposed revenue model. However, there are a handful of
significant differences that will require entities to challenge whether certain contracts fall
within the scope of the insurance model or the revenue model.
One significant difference in the proposed models relates to the timing of the recognition of
a contract. In some cases, a contract may exist under the proposed insurance model that
would not exist under the proposed revenue model. Under the proposed insurance model,
a noncancelable offer by an insurer to its customer is a triggering event that creates a
contract that must be accounted for. Under this model, the offer itself exposes the insurer
to risk and the customer‘s acceptance of the offer is generally not required for the insurer
to be at risk. Under the revenue model, one of the four criteria for a contract is that all
parties have approved the contract and are committed to satisfying their respective
obligations (see Chapter 2).
Another potential difference between the two models is the contract boundaries for those
contracts within the scope of each respective model. In the proposed insurance model,
renewal periods in which the insurer does not have the right to re-underwrite and re-price
are included in initial determination of the estimated transaction price and contract period
for purposes of measuring the contract. Conversely, under the proposed revenue
guidance, while renewal options are considered deliverables to which transaction
consideration is allocated at the inception of the contract (when and if those renewal
options are deemed to provide a material right to the customer), consideration is allocated
only to the right to purchase, not that actual good or service obtainable upon the exercise
of the option (see Section 3.5).
The accounting for contract acquisition costs will also vary between the two proposed
models. Under the proposed insurance guidance, the incremental cash outflows associated
with the acquisition of a contract become a component of the measurement of the policy
liability (fulfillment cash flows) that are recognized in income over time as the obligations of
the insurer are satisfied. Conversely, under the proposed revenue model all costs incurred to
acquire a contract (e.g., commissions) are expensed as incurred (see Section 7.2).
Finally, the presentation of revenue and costs of revenue for insurance contracts will differ
significantly from the presentation of revenue under the proposed model. Rather than
presenting revenue and cost of revenue separately in the statement of comprehensive
income, the proposed insurance model will require the recognition of only the margin on
the contract.
6 The IASB issued its exposure draft on accounting for insurance contracts on 30 July 2010;
however, the FASB has not yet issued its exposure document.
Chapter 1: Scope, transition and internal control considerations
4 Financial reporting developments The road to convergence: the revenue recognition proposal
1.2 Transition
The Boards concluded that the proposed guidance should be applied retrospectively in
accordance with ASC 2507, which they believe will provide the users of financial statements
with useful comparative information for each year presented. While the Boards noted that
retrospective application could be burdensome for some entities, particularly those with a
large number of long-term arrangements, they ultimately rejected a prospective or limited
retrospective basis of adoption. The Boards believed that a prospective method of adoption
would not provide decision-useful information because the recognition and measurement
principles being applied to new contracts would not be comparable to those applied to
existing contracts. While the Boards also considered the possibility of limited retrospective
adoption, they were unable to identify a specific date for limiting the retrospective
application of the proposed guidance that would, on a cost-beneficial basis, be preferable to
full retrospective application. The Boards ultimately concluded that the ability to apply the
exceptions to retrospective application under ASC 250 and the expected considerable time
between the issuance of a final standard and its effective date (which has not yet been
proposed) will provide users the time and flexibility necessary to apply the proposed
guidance retrospectively.
How we see it
We believe the effort required to adopt this standard will be significant for companies in
many industries, including media & entertainment and software (where long-term licenses
are common), long-term construction and for all other entities that have performance
obligations requiring an extended period to fulfill. The Boards acknowledge in the basis for
conclusions that retrospective application may be burdensome for some preparers,
particularly those with many long-term contracts.
Additionally, to adopt the proposed guidance retrospectively, an entity will prepare all
estimates based on information known at the inception of the contract or, as applicable,
during the course of the contract when estimates are revised based on new information.
We believe, and the Boards also acknowledge, that estimating the transaction price without
using hindsight (i.e., based on actual experience with collectibility and variable
consideration) and estimating standalone selling prices will be difficult for many entities.
1.3 Internal control considerations
When considering the potential effects of the proposed revenue recognition model, entities
should consider not only the potential changes in accounting policies and accounting systems
(which will be significant for many entities), but the related changes needed in internal control
processes and procedures as well. The increased use of principles and reduction of
prescriptive guidance within the proposed model will require entities to use estimation and
7 ASC 250, Accounting Changes and Error Corrections
Chapter 1: Scope, transition and internal control considerations
Financial reporting developments The road to convergence: the revenue recognition proposal 5
judgment in more areas than under today's guidance. For example, significant new estimates
and judgments could include:
► Whether a good or service includes a distinct profit margin and otherwise meets the requirements to represent a performance obligation (see Section 3.1)
► Estimated standalone selling price of performance obligations that are not sold separately (see Section 5.1)
► Variable consideration (e.g., royalties, milestone payments, payments for optional services) included in the initial estimate of the transaction consideration (see Section 4.1)
► Onerous performance obligations (see Section 7.1)
Estimation processes typically have higher levels of inherent risk associated with them than
routine data processes and, therefore, require increased internal controls. While these
changes will affect all entities, public reporting entities subject to the internal control
evaluation and reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002
("Section 404") will have to be prepared to report on these changes in internal control as well
as continue assessing whether or not internal control over financial reporting remains
effective. Further, as many of the proposed disclosure requirements (discussed further in
Chapter 8) represent new disclosures compared to today's requirements, these increased
disclosures will likely also expand the Section 404 assessment.
Chapter 2: Identify the contract with the customer
6 Financial reporting developments The road to convergence: the revenue recognition proposal
In order to apply the proposed revenue recognition model, an entity must first identify the
contract, or contracts, to provide goods and services to its customer. Any contracts that
create enforceable obligations fall under the scope of the proposed guidance and they may be
written, oral or implied by the entity‘s customary business practice. The entity‘s past business
practices may influence its determination of whether a contract exists based on whether past
practice has created an enforceable obligation.
For purposes of applying the proposed guidance, a contract exists only if all of the following
criteria are met:
► The contract has commercial substance (demonstrated when the entity‘s future cash
flows are expected to change as a result of the contract)
► The parties to the contract have approved the contract and are committed to satisfying
their respective obligations
► The entity can identify each party‘s enforceable rights regarding the goods or services to
be transferred
► The entity can identify the terms and manner of payment for those goods or services
Termination clauses within contracts are an important consideration when determining
whether a contract exists. The proposed guidance states that a contract does not exist under
the proposed model if either party can terminate a ―wholly unperformed‖ contract without
penalty. Any arrangement in which the entity has not provided the contracted goods or
services and the customer has not paid the contracted consideration is considered to be a
―wholly unperformed‖ contract.
How we see it
Oral or implied agreements
Considering oral or implied agreements to be contracts applicable to the proposed model
may be a significant change in practice for some entities. Staff Accounting Bulletin (SAB)
Topic 13 provides four criteria that must be met for the recognition of revenue, including
that ―persuasive evidence of an arrangement exists.‖ Further, SAB Topic 13 refers to
SOP 97-2 (codified in ASC 985-6058), which provides guidance on determining whether
persuasive evidence of an arrangement exists. Generally, that guidance indicates that if an
entity operates in a manner that does not rely on contracts to document formal
agreement, some other evidence must exist to document the arrangement (e.g., purchase
orders, online authorizations). Additionally, that guidance states that if an entity has a
customary business practice of using written contracts to document formal arrangements,
evidence of any arrangement exists only by a fully executed contract.
8 ASC 985-605, Software–Revenue Recognition
Chapter 2: Identify the contract with the customer
Chapter 2: Identify the contract with the customer
Financial reporting developments The road to convergence: the revenue recognition proposal 7
Example 1 — oral contract
IT Support Co. provides online technology support for consumers remotely via the
internet. For a flat fee, IT Support Co. will scan a customer‘s personal computer (PC) for
viruses, optimize the PC‗s performance and solve any connectivity problems. In many
instances, the customers must call IT Support Co. in order to obtain the services when the
customer is experiencing connectivity problems. When the customer calls to initiate the
transaction, IT Support Co. describes the services it can provide and states the price for
those services. When the customer agrees to the terms stated by the representative,
payment is made over the telephone.
In this example, IT Support Co. and its customer are entering into an oral agreement for IT
Support Co. to repair the customer‘s PC and for the customer provide consideration by
transmitting a valid credit card number and authorization over the telephone. The four
criteria above are all met with the last three criterion all met via the telephone
conversation and the charge to the customer‘s credit card.
How we see it
Considerations for change orders in construction-type contracts
The proposed model may represent a significant change in practice for unapproved, or
partially unapproved (e.g., unpriced) change orders for those construction-type contracts
within the scope of ASC 605-35. Change orders are modifications to a contract that change
the provisions of a construction-type contract without adding new provisions. In some cases,
the pricing and scope of change orders will be approved by all parties in a timely manner, but
the scope of a change order may be agreed to long before the parties agree to certain other
details, such as pricing. In some situations, the parties to the contract do not finalize the
terms and conditions of the change order until after completion of the contract.
Current guidance on contract accounting within US GAAP provides for the consideration of
change orders prior to having complete approval (i.e., prior to having a revised contract). If
it is probable that the costs will be recovered through a change in the contract price for a
partially approved change order, both costs and revenues may be recorded as equal
amounts in the period of the change. The costs may also be deferred until all parties agree
to the changes. If it is not probable that costs will be recovered through a change in the
contract price, the costs are expensed as contract costs in the period incurred (assuming
the contract price covers the costs of the change order).
Chapter 2: Identify the contract with the customer
8 Financial reporting developments The road to convergence: the revenue recognition proposal
Under the proposed guidance, an entity only applies the proposed revenue requirements to a
contract modification if the four criteria for a contract to exist are met. In any scenario in
which terms or conditions are not agreed to by both parties, the change order generally
would not be considered a contract for application of the proposed guidance. In this case,
any costs that meet the criteria for capitalization will be capitalized; otherwise, the costs
would be expensed. However, no revenue is recognized for a change order until the contract
criteria are met. This is a change in practice that may result in later recognition of revenue.
2.1 Combination and segmentation of contracts
In most cases, entities would apply the five-step model described above to individual
contracts with a customer. However, there may be situations in which the entity should
combine multiple contracts for purposes of revenue recognition. There also may be situations
that require an entity to segment single contracts in applying the proposed model.
When two or more individual contracts are linked to one another through price
interdependency, the proposed guidance requires an entity to combine those contracts and
accounts for them as a single contract. Price interdependency is generally apparent when the
amount of consideration promised for goods or services under a contract is dependent on the
amount of consideration promised under another contract. Paragraph 13 of the ED provides
the following indicators that two or more contracts have interdependent prices:
► The contracts are entered into at or near the same time
► The contracts are negotiated as a package with a single commercial objective
► The contracts are performed either concurrently or consecutively
It is important to note that the price of a particular contract is not interdependent with
another contract solely because a discount provided within the new contract is based on the
existing customer relationship (i.e., because of previous contracts between the two parties).
Determining whether multiple contracts contain interdependent pricing requires professional
judgment and depends on the facts and circumstance of each arrangement.
Chapter 2: Identify the contract with the customer
Financial reporting developments The road to convergence: the revenue recognition proposal 9
How we see it
The current multiple-element arrangements guidance within US GAAP contains a
presumption that separate contracts entered into at or near the same time with the same
entity or related parties were negotiated as a package and should be evaluated as a single
agreement. Further, ASC 605-25 is clear that the evaluation of whether multiple contracts
are treated as a single arrangement considers both the form and substance of an
arrangement. Often, vendors have continuing relationships with their customers, and this
business relationship will lead to numerous signed or oral arrangements between the two
parties. The existence of concurrent agreements suggests that these multiple agreements
may represent a single arrangement, and, as such, the timing and measurement of
revenue recognition might be affected by the terms of the overall arrangement. Further,
ASC 605-35 (for construction-type and production-type contracts) and ASC 985-605 (for
software transactions) provide guidance on when to combine separate contracts and treat
them as a single arrangement. Regardless of the underlying current ASC guidance, the
determination of whether to combine contracts requires the use of professional judgment
and careful consideration of all facts and circumstances.
The three indicators provided in the ED are generally consistent with the underlying
principles in the current ASC guidance on combining contracts. As a result, we anticipate
the proposed guidance will result in entities reaching similar conclusions about when to
combine contracts as they do today.
Conversely, an entity may determine that it is necessary to segment a single contract and
account for it as two or more contracts if the prices of goods or services promised in the
contract are independent of the prices of other goods or services in the contract. Under the
proposed model, goods or services are priced independently of other goods or services in the
same contract only if both of the following conditions are met:
► The entity, or another entity, regularly sells identical or similar goods or services separately
► The customer does not receive a significant discount for buying some goods or services
together with other goods or services in the contract
Based on the above, one might conclude that if a customer receives a significant discount for
buying some goods or services with other goods or services in the contract, the contract
should not be segmented. However, in the basis for conclusions, the Boards state that if the
entity has evidence that a discount relates only to some goods or services within a contract,
then the contract may still meet the criteria for segmentation. This indicates that an entity
does not have to assume that a discount for a particular good or service is a result of buying
the bundle of goods and services.
Chapter 2: Identify the contract with the customer
10 Financial reporting developments The road to convergence: the revenue recognition proposal
Once an entity determines that segmenting a contract is appropriate, the entity allocates the
total expected consideration to each identified segment of the contract in proportion to the
standalone selling prices of the goods or services within each identified segment. The
transaction price allocated to each segment is then allocated to the individual performance
obligations within each segment, as applicable. Subsequent changes in the amount of
expected consideration are allocated only to the identified segment to which those changes
relate. For example, any changes in the expected consideration due to changes in expected
variable consideration are allocated to the segment giving rise to the variability.
How we see it
There is little current US GAAP on segmenting a contract. Criteria for segmenting certain
long-term production-type or construction-type contracts exist within the guidance on
construction-type and production-type contracts in ASC 605-35, but segmenting generally
is considered optional, not mandatory, under that guidance. As a result, the concept of
segmenting a contract will likely be new to most entities. However, it is unclear how
frequently entities would actually segment a contract under the proposed guidance, as it
seems unlikely that the criteria discussed above would be met frequently. Further, in those
scenarios where the criteria are met, it seems less likely that segmenting the contract will
provide a different accounting result than simply identifying separate performance
obligations. The following scenarios illustrate this point.
Example 2 — segmenting a contract
Assume Company Z enters into a single contract to sell a handheld electronic gaming
device and two games for $300. Company Z determines that the handheld device and both
games are each distinct based on the proposed guidance; therefore, each product
represents a separate performance obligation under the contract. The standalone selling
prices of the handheld device and each game are $250, $25 and $25, respectively.
Company Z sells the three products separately and the customer is not receiving a
significant discount by purchasing the goods together. In this scenario, the contract meets
the criteria to be segmented; however, the treatment of the handheld device and two
games as three individual contracts (segments) or as three separate performance
obligations under one contract has no effect on the amount of promised consideration
allocated to each performance obligation and, accordingly, no effect on the timing of the
revenue recognized. That is, regardless of whether consideration is allocated to three
contract segments or three performance obligations, the allocation is performed on a
relative selling price basis.
Chapter 2: Identify the contract with the customer
Financial reporting developments The road to convergence: the revenue recognition proposal 11
Assume the same fact pattern as above, except that the customer is eligible to receive a
$30 rebate on the handheld device if the customer submits the appropriate paperwork.
Company Z provides this same rebate offer to customers purchasing the handheld on a
standalone basis. In this fact pattern, because the $30 in variable consideration is
attributable only to the handheld device, segmenting the contract may affect the timing of
revenue recognition. If Company Z segments the contract, the adjustment to the
estimated transaction price resulting from the probability-weighted expected rebate
redemptions is allocated in its entirety to the handheld device. Conversely, if Company Z
concludes the contract should not be segmented, the adjustment to the estimated
transaction price resulting from the rebate is allocated to all three performance obligations
based on relative standalone selling price (discussed further below in Section 5.2).
2.2 Contract modifications
When the parties modify a contract subsequent to contract inception, the entity must
determine whether the modification creates a new contract or whether the contract
modification should be combined with the existing contract. A contract modification is
described in the proposed guidance as any change in the scope or price of a contract,
initiated by any party to the contract. Paragraph 17 of the ED provides that a contract
modification may include a change in the nature or amount of the goods or services promised
to the customer, a change in the method or timing of performance under the contract by any
party or a change in the previously agreed pricing in the contract.
In their basis for conclusions, the Boards explain that modifications to contracts should follow
the same principles as those applied to the segmentation or combination of contracts. Under
the proposed model, if the contract modification is tied to the original contract through price
interdependency, the modified terms are accounted for as part of the original contract.
Alternatively, if the modifications to the contract provides for the provision of goods or
services priced independently, the additional goods or services are viewed as performance
obligations in a new contract accounted for independently.
The effect on the amount and timing of revenue recognition at the date of the contract
modification differs based on whether or not the modification is accounted for together with
the existing contract. A modification accounted for together with the existing contract
requires a reallocation of the consideration to the identified performance obligations. To the
extent the reallocation of transaction consideration affects satisfied performance obligations,
the entity would recognize the cumulative effect of the contract modification (positive or
negative) in the period the modification occurs. In effect, the cumulative accounting for a
contract modification would result in revenue recognized as though the modified terms had
been included in the existing contract. Conversely, if the entity concludes that the contract
modification results in a new contract, the entity would apply the proposed model separately
to the new performance obligations included in the contract modification.
Chapter 2: Identify the contract with the customer
12 Financial reporting developments The road to convergence: the revenue recognition proposal
Example 3 — contract modification
The Boards provide the following example in Paragraph IG3 of the ED to demonstrate the
accounting for contract modifications:
Scenario 1—services that do not have interdependent prices
An entity enters into a three-year services contract. The payment terms are $100,000
payable annually in advance. The standalone selling price of the services at contract
inception is $100,000 per year. At the beginning of the third year (after the customer had
paid the $100,000 for that year), the entity agrees to reduce the price for the third year of
services to $80,000. In addition, the customer agrees to pay an additional $220,000 for
an extension of the contract for 3 years. The standalone selling price of the services at the
beginning of the third year is $80,000 per year.
To account for the contract modification, the entity must evaluate whether the price of the
services provided before the contract modification and the price of the services provided
after the contract modification are interdependent. The services provided during the first 2
years are priced at the standalone selling price of $100,000 per year. Moreover, the
services provided during the subsequent 4 years are priced at the standalone selling price of
$80,000 per year. Hence, the entity concludes that the price of the contract modification
and the price of the original contract are not interdependent. Although the services are
provided continuously, the price of the services in the first 2 years and the price of the
subsequent services are negotiated at different times and in different market conditions (as
evidenced by the significant change in the standalone selling price of the service).
Consequently, the entity accounts for the contract modification separately from the
original contract. $20,000 of the $100,000 payment received at the beginning of the
third year (before the modification) is a prepayment of services to be provided in the
future years. Therefore, the entity recognizes revenue of $100,000 per year for the 2
years of services provided under the original contract and $80,000 per year for services
provided during the subsequent 4 years of services under the new contract.
Chapter 2: Identify the contract with the customer
Financial reporting developments The road to convergence: the revenue recognition proposal 13
Scenario 2—services that have interdependent prices
The facts are the same as Scenario 1 except that at the beginning of the third year the
customer agrees to pay an additional $180,000 for an extension of the contract for 3 years.
The services provided during the first 2 years are priced at their standalone selling price of
$100,000 per year. However, the services provided during the subsequent 4 years are
priced at a $40,000 discount [($80,000 standalone selling price per year × 4 years) –
($100,000 prepayment + $180,000 remaining payment)] and, therefore, their price is
dependent on the price of the services in the original contract. Hence, the entity concludes
that the price of the contract modification and the price of the original contract are
interdependent.
Consequently, the entity accounts for the contract modification together with the original
contract. At the date of modification, the entity recognizes the cumulative effect of the
contract modification as a reduction to revenue in the amount of $40,000 [($480,000 total
consideration ’ 6 years of total services × 2 years‘ services provided) − $200,000 revenue
recognized to date]. The entity recognizes revenue of $100,000 per year for the first 2
years‘ $40,000 in the third year, and $80,000 per year in the fourth, fifth, and sixth years.
How we see it
In certain industries, parties frequently modify contractual arrangements before
completion. Entities will have to determine whether such change orders are separate
contracts or modifications of the original contract under the proposed model. This
assessment will require the use of judgment as it will frequently be difficult to determine
whether the pricing of the change order is interdependent upon the pricing in the original
contract. The requirement to determine whether to treat a change order as a separate
contract or a modification to an existing contract is relatively consistent with current US
GAAP. However, the application of the requirement may change as a result of the
proposed guidance, resulting in different conclusions in some cases.
Chapter 3: Identify the separate performance obligations in the contract
14 Financial reporting developments The road to convergence: the revenue recognition proposal
A performance obligation is defined in the ED as ―an enforceable promise (whether explicit or
implicit) in a contract with a customer to transfer a good or service to the customer.‖ The
proposed guidance requires an entity to identify all promised goods and services and
determine whether to account for each good or service as a separate performance obligation.
Paragraph 21 in the ED provides examples of goods or services that may give rise to a
performance obligation.
Excerpt from the ED
21. Contracts with customers oblige an entity to provide goods or services in exchange for
consideration. Goods or services include the following:
(a) goods produced by an entity for sale (for example, inventory of a manufacturer);
(b) goods purchased by an entity for resale (for example, merchandise of a retailer);
(c) arranging for another party to transfer goods or services (for example, acting as an
agent of another party);
(d) standing ready to provide goods or services (for example, when- and if-available
software products);
(e) constructing or developing an asset on behalf of a customer;
(f) granting licenses, rights to use and options; and
(g) performing a contractually agreed task (or tasks).
How we see it
Properly identifying the individual performance obligations within a contract is a critical
component of the proposed revenue model as revenue allocated to each performance
obligation is recognized as each performance obligation is satisfied. Additionally, as
discussed further in Section 7.1, whether or not an arrangement contains onerous
components is determined at the performance obligation level.
The concept of identifying separate performance obligations is similar to identifying a
deliverable or element under current US GAAP. As a result, we believe that in many cases
entities that transact in multiple-element arrangements will identify a similar number of
goods and services under the proposed model as they do under current US GAAP.
Chapter 3: Identify the separate performance obligations in the contract
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 15
However, the new guidance likely will have a significant effect on entities that do not
currently account for revenue transactions under the guidance for multiple-element
arrangements. For example, the guidance in ASC 605-35 for certain production-type and
construction-type contracts does not require an entity to identify the individual goods and
services within an arrangement. Under the proposed model, in a contract to construct an
office building, the construction firm may consider the (a) customized design, (b) engineering
and (c) construction to each represent separate performance obligations. Alternatively, the
construction firm may determine that the activities included within those services, such as
the erection the physical building, the electrical wiring within the building, and the heating,
cooling and ventilation within the building, represent separate performance obligations.
Since the model requires the evaluation of identified goods and services to determine
whether they are separate performance obligations, and the satisfaction of performance
obligations drives revenue recognition, the identification of goods and services is an
important first step. While the ED provides illustrative guidance on this topic, it remains
unclear exactly how this guidance applies to transactions that contain numerous steps to
complete. We expect that the guidance in this area, and the interpretation of this guidance,
will continue to evolve as the Boards move toward a final standard.
3.1 Distinct goods and services
In order to identify the performance obligations within an arrangement, an entity determines
which promised goods and services are distinct from one another. That is, distinct goods and
services are considered individual performance obligations. Contracts to provide goods and
services to customers will often contain multiple performance obligations.
The ED provides criteria for determining whether a good or service is distinct in Paragraph 23.
Excerpt from the ED
23. A good or service, or a bundle of goods or services, is distinct if either:
(a) The entity, or another entity, sells an identical or similar good or service separately
Or
(b) The entity could sell the good or service separately because the good or service
meets both of the following conditions:
i. It has a distinct function — a good or service has a distinct function if it has
utility either on its own or together with other goods or services that the
customer has acquired from the entity or are sold separately by the entity or
by another entity
ii. It has a distinct profit margin — a good or service has a distinct profit margin if it
is subject to distinct risks and the entity can separately identify the resources
needed to provide the good or service
Chapter 3: Identify the separate performance obligations in the contract
16 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
The determination of whether a good or service is distinct may in many cases be subjective
and require the application of considerable professional judgment. The best evidence that a
good or service is distinct is when the good or service is sold separately by the entity or any
other market participant.
Multiple-element transactions
Consistent with the determination of standalone value under current US GAAP, the
determination of whether or not a good or service is a distinct performance obligation may
require the use of judgment. When the good or service is sold separately, the conclusion is
straightforward. However, in the absence of standalone sales, the entity may still
determine that the good or service is distinct by showing that the good or service, while not
currently sold separately, could be sold separately. The Boards provide two criteria that
must be met to support that assertion — 1) the good or service has a distinct function and
2) the good or service has a distinct profit margin. Requiring that a good or service has a
distinct function is consistent with the guidance in ASC 605-25, which requires that a
deliverable have ―value to the customer on a standalone basis.‖ That is, for a good or
service to have a distinct function (i.e., the good or service has utility on its own or when
combined with another asset), the good or service is essentially required to be an asset
that generates some economic benefit (i.e., value) to the customer.
The criterion in the proposed guidance that the good or service have a distinct profit
margin, however, is not one that exists currently in ASC 605-25. While not included in
ASC 605-25, this concept is similar to the guidance on construction-type contracts in
ASC 605-35 that requires an element to have a different rate of profitability to be
accounted for separate from other elements. When a standalone selling price is known, the
profit margin is readily determinable in most cases. However, demonstrating a distinct
profit margin when a selling price is not observable (because the good or service is not sold
separately) is difficult. The Boards concluded that in the absence of an observable selling
price, the entity would have sufficient basis for estimating the selling price only when the
good or service is subject to distinct risks and the entity can identify the distinguishable
resources needed to provide the good or service. This represents a significant change in
the accounting for multiple-element arrangements today.
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 17
In summary, when an entity is unable to identify the resources necessary to deliver a good
or service when the good or service is not sold separately, it may not be able to
demonstrate a distinct profit margin and would, therefore, not account for the identified
performance obligation separately. We anticipate that this requirement will most
frequently affect transactions that include certain intangibles not sold on a standalone
basis, such as software always bundled with postcontract customer support (PCS). This is
because it will likely be difficult for entities to determine the standalone selling price for the
software and, for many entities, the same resources are used to create software
intellectual property as are used to provide PCS (e.g., development of if-and-when
available upgrades). It appears that under the proposed model, in such situations, the
software license may have to be combined with the PCS into a single performance
obligation.
Other transactions
The identification of multiple performance obligations within a single contract may
represent a significant change to certain transactions. For example, for those transactions
that currently fall under the guidance in ASC 605-35 on accounting for production-type
and construction-type arrangements, the proposed guidance is a significant change. The
guidance in ASC 605-35 generally allows the accounting for contracts to be based on the
entire contract (although segmenting does occur in limited circumstances). However, we
do not believe the proposed guidance would provide for a similar outcome, and expect that
entities with these types of arrangements frequently will identify multiple performance
obligations in each contract, based on the proposed model.
During the deliberations and drafting of the proposed model, the Boards received feedback
that it was difficult to understand the extent to which an entity would have to identify
goods and services, and the resulting performance obligations, in contracts containing
many goods and services, such as the construction of a building. While the Boards have
made clear that they do not believe an entity would have to identify every nail and brick as
a good or service, we believe it is still unclear as to what level of granularity an entity is
required to use to identify goods and services in applying the proposed model.
If a good or service is not distinct from the other goods and services in the contract, the
entity is required to combine that good or service with other promised goods or services until
a bundle of goods or services is distinct for purposes of applying the proposed model. The
combination of multiple goods or services could result in the entity accounting for all the
goods or services promised in the contract as a single performance obligation.
Chapter 3: Identify the separate performance obligations in the contract
18 Financial reporting developments The road to convergence: the revenue recognition proposal
The requirement to combine goods or services that are not distinct with other goods or
services is a critical component of the proposed model, and may have a significant effect on
the timing of revenue recognition. It is important to understand that this requirement may
result in combining a good or service with other goods or services that, on their own, meet the
definition of distinct. Example 11 in the ED (Paragraph IG43) illustrates the bundling of certain
goods or services with other goods and services that will be delivered under the contract. In
that example, the construction firm identifies the following individual goods or services:
► Design services (engineering)
► Construction activities, including:
► Site preparation
► Foundation development
► Structure erection
► Piping
► Wiring
► Site finishing
► Contract management services
In the illustration, the entity concludes the design services are distinct because similar
services are sold separately by the entity and by its competitors. Further, the entity
concludes that while many of the construction activities are distinct, the contract
management services are not. Based on that conclusion, the entity determines it must
combine the contract management services with other goods and services until the bundle of
goods and services is distinct. In this example, the entity combines the contract management
services with a number of the construction-related goods and services (foundation
development, structure erection, piping, and wiring) as the entity determines they are all
related tasks and have inseparable risks. However, the entity determines the site preparation
and site finishing, while construction-related activities, have distinct risks and are therefore
separable from the other construction activities. As a result, in this example, the entity
ultimately concludes it has four distinct performance obligations: design services, site
preparation, construction activities and site finishing.
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 19
How we see it
The determination of whether or not a good or service should be treated as a distinct
performance obligation, as discussed above, is one that will require significant judgment.
However, if there are goods and services that are not distinct, the determination of which
other goods and services to combine them with will also require significant judgment, and
likely may provide different results than under current US GAAP today.
Generally, under current US GAAP for multiple element arrangements, when an element
cannot be accounted for separately (e.g., because it lacks standalone value), that element
is combined with the last delivered element. This results in the deferral of revenue
associated with that element until the last element in the contract is delivered. However, all
other elements that were determined to have standalone value remain unaffected and
continue to be accounted for separately. Conversely, under the proposed guidance, if an
entity determines that a good or service is not distinct, that good or service must be
combined with other goods and services until a distinct bundle of goods is identified. As
illustrated in the example above, an entity may combine nondistinct goods or services with
other goods or services that are distinct on their own. In that example, the Boards
concluded that the construction management services would be combined with certain
highly interrelated goods or services that shared similar risks. However, it remains unclear
how an entity makes the determination of which activities have similar risks.
When an entity transfers multiple goods or services to a customer at the same time,
the proposed guidance does not require the application of the proposed model to each
performance obligation separately if applying the proposed model to them together
would result in the same amount and timing of revenue recognition as if they were
accounted for separately.
How we see it
Although the proposed guidance does not require application of the recognition and
measurement guidance to each performance obligation when the performance obligations
are delivered to the customer at the same time, the disclosure requirements in the proposed
guidance, described in further detail in Section 8.2, may require those same performance
obligations to be identified and presented separately in disaggregated disclosures. As a
result, while an entity may not be required to separately identify which goods and services
delivered at the same time are separate performance obligations for revenue recognition
purposes, the entity may have to make that distinction for disclosure purposes.
Chapter 3: Identify the separate performance obligations in the contract
20 Financial reporting developments The road to convergence: the revenue recognition proposal
3.2 Product warranties
Product warranties are commonly included in the sale of goods, whether explicitly stated or
implied based on the entity‘s customary business practices. Further, the price of warranties
may be included in the overall purchase price or separately listed in the agreement as an
optional product. The proposed guidance identifies two specific classes of warranties those
that cover latent defects (i.e., defects that existed at the time the goods were transferred to
the customer) and those that cover defects arising subsequent to the transfer of the goods.
3.2.1 Quality assurance warranties
The Boards concluded that warranties covering latent defects do not provide an additional
good or service to the customer (i.e., are not separate performance obligations). Instead, in
that circumstance the entity has not fulfilled its original performance obligation as it has
failed to provide a product free of defects. By providing this type of warranty, the selling
entity has effectively provided a quality assurance guarantee. For arrangements that include
a quality assurance warranty, the entity would evaluate its product sales to determine the
likelihood and extent of any defects in the products sold to its customers, updating this
analysis at each financial reporting date.
The amount of revenue deferred for quality assurance warranties is dependent upon the
entity‘s obligation under the warranty. When the entity is required to fully replace a defective
product, the ED stipulates that the entity may not record any revenue associated with that
unsatisfied performance obligation. Conversely, if the entity is required to repair a defective
product, the entity defers only that the portion of the transaction price attributed to the
components expected to be repaired or replaced. As the proposed model does not require the
allocation of consideration down to components of a product, it does not address how an
entity would defer revenue associated with a component of a product. However, based on
discussions with the Boards‘ staffs, we understand that one acceptable method would be to
measure the estimated selling price of the component by identifying the costs associated with
repairing or replacing the component and adding an appropriate margin.
Frequently, after an entity provides a good or service, conditions arise that effect the original
estimate of expected experience associated with quality assurance warranties. For example,
an entity may discover two months after a product is shipped that a part acquired from a
third-party manufacturer is defective and that a large percentage of those parts are going to
fail. Under the proposed model, an entity would reflect any revisions to estimates associated
with quality assurance warranties as an adjustment to the amount of revenue recognized for
the related performance obligation (as a quality assurance warranty actually represents an
unsatisfied performance obligation).
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 21
Example 4 — quality assurance warranty to replace defective part
An entity manufactures and sells video game cartridges. The entity replaces any defective
game cartridges within the first 90 days of sale. Based on the entity‘s historical
experience, it determines (based on a probability-weighted average calculation) it has a 5%
defect rate on cartridges sold. Assuming the entity sells 100 game cartridges for $40
each, it would record the following entries:
Dr. Cash/Receivables 4,000
Cr. Contract liability 200
Cr. Revenue 3,800
The entity recognizes the contract liability as revenue during the 90 days of the quality
assurance warranty period as it repairs or replaces defective parts (i.e., as it satisfies the
original performance obligation).
Thirty days after the entity sells its game cartridges, it discovers that the coprocessor chip
included in some of the games is defective. The entity now believes it will have a 20%
defect rate. As a result, the entity estimates $800 of the transaction price should be
deferred (rather than the $200 originally deferred). The entity would record this change in
estimate on the remaining performance obligation by recording the following entry:
Dr. Revenue 600
Cr. Contract liability 600
Example 5 — quality assurance warranty to repair defective part
Conversely, if the entity repairs, rather than replaces the defective cartridges, it would
initially defer only the revenue associated with the component of the game cartridges that
it expects to repair. If the entity estimates that it costs $12 to replace the defective
component of the cartridge and that a 50% margin is appropriate, it will defer $18 for each
expected defective cartridge, or $90 total (5 cartridges X $18 of transaction price
allocated to the warranty component), and record the following entries:
Dr. Cash/Receivables 4,000
Cr. Contract liability 90
Cr. Revenue 3,910
3.2.2 Insurance warranties
If an entity offers a warranty that provides coverage beyond defects that existed at the time
of the sale, in essence the entity has provided an insurance warranty to the customer. The
Boards determined that this type of warranty represents a separate warranty service (i.e., an
―insurance warranty‖) and, therefore, represents an additional performance obligation.
Unlike a quality assurance warranty in which the delivery of defect-free goods is presumed to
Chapter 3: Identify the separate performance obligations in the contract
22 Financial reporting developments The road to convergence: the revenue recognition proposal
have not yet occurred (thus, the performance obligation for delivery of the good is not yet
satisfied), the entity accounts for an insurance warranty by allocating a portion of the
transaction price to a separate performance obligation (the insurance warranty). The revenue
related to that portion of the transaction price is then recognized over the period the
warranty services are provided. We believe that in many cases an entity may determine that
the warranty service is provided continuously over the warranty period (i.e., the performance
obligation is an obligation to ―stand-ready to perform‖ during the stated warranty period).
Frequently, after an entity provides a good or service, conditions arise that effect the
original estimate of expected experience associated with insurance warranties. For example,
an entity may discover two months after a product is shipped that the cost of a part acquired
from a third-party manufacturer has tripled and it will cost the entity significantly more to
replace that part if a warranty claim is made. However, unlike quality assurance warranties
(for which the entity reflects any revisions to estimates as an adjustment to the number of
performance obligations satisfied, with a corresponding effect on the amount of revenue
recognized), the revenue allocated to an insurance warranty is not modified. This is because
the allocation of transaction consideration is based on the standalone selling price at the
time of the transaction and, under the proposed model, subsequent changes to standalone
selling prices are not reflected in the relative selling price allocation. (See Section 3.2.5
below for a further discussion of how the expected costs would be accounted for under the
proposed model.)
Example 6 — insurance warranty
An entity manufactures and sells computers, which include a quality assurance warranty
for the first 90 days. Additionally, the entity offers its customers an optional ―extended
coverage‖ plan under which the entity will repair or replace any defective part for three
years from the expiration of the quality assurance warranty. The entity determines that
the three years of extended coverage represent a separate performance obligation, as
during that period the entity will repair or replace parts with defects that did not exist at
the time of the sale of the product. The total transaction price for the sale of a computer
and the extended warranty is $3,600 and the entity determines the standalone selling
price of each is $3,200 and $400, respectively. Further, the entity uses a probability-
weighted average calculation (based on historical experience) and estimates it will incur
$200 in costs to repair latent defects that arise within the 90-day coverage period for the
quality assurance warranty. Based on the margin associated with the computer, the entity
determines a 40% margin is appropriate for those costs. As a result, the entity will record
the following entries:
Dr. Cash/Receivables 3,600
Cr. Contract liability (quality assurance warranty) 280
Cr. Contract liability (insurance warranty) 400
Cr. Revenue 2,920
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 23
The entity recognizes the contract liability associated with the quality assurance warranty
as revenue during the 90 days of the quality assurance warranty period as it repairs or
replaces defective parts (i.e., as the entity satisfies the original performance obligation).
The entity recognizes the contract liability associated with the insurance warranty as
revenue during the contract warranty period.
3.2.3 Differentiating between quality assurance and insurance
warranties
In certain circumstances, it may be difficult to determine whether a warranty is simply
providing coverage for latent defects or if it is providing additional warranty services. In
assessing the objective of the product warranty, Paragraph IG18 of the ED provides that the
entity should consider factors such as the following:
► Whether the warranty is required by law - if the entity generally is required by law to
protect the consumer from the risk of purchasing a defective product, this indicates a
warranty providing such coverage is a quality assurance warranty
► Whether the product could have been sold without the warranty — when the entity can sell
the product without the warranty, it indicates the entity may not have an obligation to
cover latent defects and that the inclusion of a warranty is an insurance warranty
► The length of the warranty coverage period — generally, the longer the warranty period, the
higher the likelihood that the warranty (or part of the warranty) is an insurance warranty
Despite the inclusion of these factors within the proposed guidance, we believe it will often be
difficult for the entity to determine which type of warranty is being provided. For example,
many manufacturers provide long-term warranties on their products (e.g., a four-year
warranty provided by an auto manufacturer). Based on conversations with the FASB staff, we
understand that the staff believes an entity may conclude that those long-term warranties
are quality assurance warranties despite the length of the warranty. As a result, it is possible
that diversity in practice will exist in determining the classification of the type of warranty
issued for warranties with similar coverage terms.
3.2.4 Combination warranties
If an entity‘s warranty coverage covers both latent defects and defects arising after the time
of sale, the entity will have to account for both types of warranties under the proposed
model. While the ED does not explicitly illustrate a scenario in which a single warranty
provision serves both purposes, paragraph IG18 in the ED includes a parenthetical reference
to the potential for part of a warranty to be considered a performance obligation. In applying
the proposed model, the entity would allocate a portion of the transaction price to the
insurance warranty based on its relative standalone selling price, and account for the quality
assurance warranty separately from the insurance warranty.
Chapter 3: Identify the separate performance obligations in the contract
24 Financial reporting developments The road to convergence: the revenue recognition proposal
Example 7 — combination warranty
An entity manufactures and sells cars. For most car models sold, the entity provides a
four-year, 48,000-mile quality assurance warranty. However, as part of a sales promotion,
the entity decides to offer a particular model with a 10-year, 100,000 mile warranty. The
entity determines that the 10-year warranty represents both a quality assurance and
insurance warranty. As the entity believes its standard warranty (4-years, 48,000 miles) is
a quality assurance warranty (see Section S3.2.3), it determines the extended period (the
additional 6-years, 52,000 miles) of coverage represents the insurance warranty.
Under the proposed model, the entity determines the standalone selling price for the
insurance warranty and accounts for that performance obligation separately. The entity
reaches the conclusion that the sale of the car includes two performance obligations, the
car itself (which has a quality assurance warranty associated with it) and the insurance
warranty for the extended period of coverage. The total transaction price is $32,000.
Based on a relative standalone selling price allocation, the entity allocates $29,500 to the
car and $2,500 to the insurance warranty. Further, using a probability-weighted average
estimate based on historical experience, the entity expects to incur $1,500 in costs
associated with repairing or replacing defective components of each car during the earlier
of four years or 48,000 miles after the car is delivered to the customer. Based on the
margin associated with the car, the entity determines a 20% margin is appropriate and
therefore defers $1,800 of the transaction price allocated to each car to reflect its
remaining performance obligation for the car. The entity would record the following entries:
Dr. Cash/Receivables 32,000
Cr. Contract liability (quality assurance warranty) 1,800
Cr. Contract liability (insurance warranty) 2,500
Cr. Revenue 27,700
The entity recognizes the contract liability associated with the quality assurance warranty
as revenue during the quality assurance warranty period (4 years or 48,000 miles) as it
repairs or replaces of defective parts, (i.e., as the entity satisfies the original performance
obligation). The entity recognizes the contract liability associated with the insurance
warranty as revenue during the contract warranty period (once the quality assurance
warranty period has ended through the earlier of 10 years or 100,000 miles).
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 25
3.2.5 Warranty costs
Costs associated with fulfilling a warranty obligation, whether the warranty is a quality
assurance warranty or an insurance warranty, are expensed when incurred under the
proposed model. However, as discussed above, the treatment of changes in expected costs to
fulfill warranty obligations may differ depending on the type of warranty. Changes in
expected costs for quality assurance warranties are immediately reflected in an adjustment
to revenue. Further, if those costs increase to a level at which the expected costs exceed the
entire amount of transaction price allocated to the performance obligation, the entity may
have to recognize a liability for an onerous performance obligation. For example, an auto
parts supplier provides seats to an auto manufacturer. As the supplier works extensively with
the auto manufacturer on the design and specifications before providing the seat, it rarely
has quality assurance issues. However, in the rare instances defects do arise, the auto
manufacturer is forced to recall the automobiles with defective seats. The costs of the recall,
removing the defective seat and replacing it with a new seat will frequently exceed the
original amount of revenue recognized for the seat when sold to the auto manufacturer. As a
result, under the proposed model, the supplier will be required to reverse all revenue
recognized related to the seat, and account for any expected excess costs (compared to the
revenue reversed) as an onerous performance obligation. See Section 7.1 for further
discussion on onerous performance obligations.
Entities are required to continually assess their warranty provisions based on current
information to ensure that changes in the entity‘s environment or obligations are reflected in
the liability. These adjustments likely reflect both changes in the expected quantity of product
requiring repair and changes in the expected cost of completing the repair. It is unclear how
changes in expected costs of fulfilling warranty obligations will be accounted for under the
proposed model. While it seems contrary to the model to adjust the amount of revenue
associated with a quality assurance warranty when only the estimated costs have changed,
most entities do not track changes in cost estimates separately from changes in the quantity
of product requiring repair. As a result, previously recognized revenue may have to be
adjusted for revisions to both costs and quantities.
Conversely, for insurance warranties, changes in expected costs are not reflected as an
adjustment to revenue recognized. Because insurance warranties are treated as a separate
performance obligation, when cost estimates change, the entity is required to assess whether
or not the increase in costs have created an onerous performance obligation. If the entity
expects the present value of the costs to fulfill that warranty performance obligation to
exceed the transaction consideration allocated to the warranty services, the entity would be
required to recognize a liability and corresponding expense for the excess costs. See the
discussion of onerous contracts in Section 7.1.
Chapter 3: Identify the separate performance obligations in the contract
26 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
Under the proposed model, any obligation related to either quality assurance warranties or
insurance warranties results in an initial deferral of revenue, which is then recognized as
the warranty services are provided. As a result, in comparison to current US GAAP, the
timing of revenue recognition will be affected for all transactions including a quality
assurance warranty because current practice generally provides for the recognition of
revenue in full and the accrual of a liability for the incremental cost of satisfying the
warranty obligation. We do not expect there to be a significant change in the accounting
for separately priced extended warranties (insurance warranties). While the amount of
revenue allocated to such warranties will change (current US GAAP requires the stated
contractual amount versus the relative selling price allocated under the proposed model),
revenue related to such warranties generally is recorded ratably over the warranty period
under both the proposed model and under current US GAAP.
We believe it frequently will be difficult to distinguish between the two types of warranties.
As highlighted above, an entity has to account for changes in estimated costs associated
with fulfilling warranty obligations in a very different manner depending on the type of
warranty involved. This difference in treatment makes the distinction of which type of
warranty the entity is providing a significant one.
Additionally, the proposed requirement for the recognition of warranty costs as incurred
also represents a change in practice from current US GAAP for other than separately
priced warranties, under which warranty costs are estimated and accrued upon the sale of
the good. Under the proposed model, warranty costs are recognized before they are
incurred only in situations in which the costs of satisfying the obligation are expected to
exceed the transaction price associated with the related performance obligation and,
therefore, an onerous performance obligation exists.
3.3 Principal versus agent considerations
Certain sales contracts often result in an entity‘s customer receiving goods or services from
another entity that is not a direct party to the contract. The ED states that when other parties
are involved in providing goods or services to an entity‘s customer, the entity must determine
whether its performance obligation is to provide the good or service itself (i.e., the entity is a
principal), or to arrange for another party to provide those goods or services (i.e., the entity
is an agent). The determination of whether the entity is acting as a principal or an agent
determines whether revenue is recognized at the gross amount when the entity is a principal
or, when the entity is an agent, at the net amount after the principal (i.e., the supplier of the
goods) is compensated.
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 27
A principal‘s performance obligations in a transaction differ from an agent‘s performance
obligations. Since the principal controls the goods or services before delivery to the
customer, its performance obligation is to transfer those goods or services to the customer in
accordance with the contract. The agent only facilitates the sale of goods or services to the
customer in exchange for a fee or commission and never controls the goods or services prior
to delivery. Therefore, the agent‘s performance obligation is to arrange for another party to
provide the goods or services to the customer.
Because the identification of the principal in a contract is not always clear, the Boards
provided implementation guidance in Paragraph IG22 with indicators that a performance
obligation involves an agency relationship.
Excerpt from the ED
IG22. Indicators that the entity‘s performance obligation is to arrange for the provision of
goods or services by another party (that is, that the entity is an agent and shall
recognize revenue net) include the following:
(a) the other party is primarily responsible for fulfillment of the contract;
(b) the entity does not have inventory risk before or after the customer order, during
shipping or on return;
(c) the entity does not have latitude in establishing prices for the other party‘s goods
or services and, hence, the benefit that the entity can receive from those goods or
services is constrained;
(d) the entity‘s consideration is in the form of a commission; and
(e) the entity does not have customer credit risk for the amount receivable in
exchange for the other party‘s goods or services.
Although a principal may be able to relieve itself from the obligation to provide goods or
services by transferring that obligation to another party, the Boards have indicated that such
transfer may not always satisfy the performance obligation. Instead, the entity evaluates
whether it has created a new performance obligation to obtain a customer for the entity that
assumed the obligation (i.e., whether the entity is now acting as an agent).
How we see it
Existing US GAAP requires an entity to assess whether it is acting as a principal or an agent
when goods or services are transferred to end customers and the principles provided in the
proposed model are similar to the principles in the current standards. Therefore, we do not
expect significant changes in practice with regard to principal/agency relationship
determinations.
Chapter 3: Identify the separate performance obligations in the contract
28 Financial reporting developments The road to convergence: the revenue recognition proposal
3.4 Consignment arrangements
Entities frequently deliver inventory on a consignment basis to other parties (e.g., distributor
or dealer). By shipping on a consignment basis, consignors are able to better market products
by locating them closer in proximity to the end user; however, they do so without selling the
goods to the intermediary (consignee).
Entities entering into a consignment arrangement must determine, upon delivery of the
inventory to the consignee, whether control of the inventory has passed to the consignee.
Typically, a consignor will not relinquish control of consignment inventory until the inventory is
sold to the end consumer or, in some cases, when a specified period expires. Additionally,
consignees commonly do not have any obligation to pay for the inventory other than to pay the
consignor the agreed portion of the sale price once the consignee sells the product to a third
party. As a result, revenue generally should not be recognized for consignment arrangements
when the goods are delivered to the consignee as control has not been transferred (i.e., the
performance obligation to deliver goods to the customer has not been satisfied).
How we see it
We do not expect the accounting for consignment arrangements to change significantly
under the proposed model. Current US GAAP requires an entity to determine whether the
risks and rewards of ownership have passed to the consignor, which in most cases will
correspond to the time that control has passed to the consignor under the proposed
guidance. See the discussion on differences between control and risks and rewards of
ownership in Chapter 6.
3.5 Customer options for additional goods
Many sales contracts allow customers the option to purchase additional goods or services.
These additional goods and services may be at a discount or even free of charge. Options to
acquire additional goods or services at a discount can come in many forms, including sales
incentives (e.g., free telephones), customer award credits (e.g., frequent flier programs),
contract renewal options (e.g., waiver of certain fees, reduced future rates) or other
discounts on future goods or services.
The proposed guidance states that when an entity grants a customer the option to acquire
additional goods or services, that option is a separate performance obligation only if it
provides a material right to the customer. The right would be material only if it results in a
discount that the customer would not receive otherwise (e.g., a discount that is incremental
to the range of discounts typically given for those goods or services to that class of customer
in that geographical area or market). If the discounted price in the option is within the range
of prices typically offered to other similar customers (separate from any existing relationship
or contract), the entity is deemed to have made a marketing offer rather than having granted
a material right. The assessment as to whether the entity has granted its customer a material
right will likely require judgment.
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 29
Example 8 — option that is not a performance obligation
A telecom entity provides its customers the option to purchase additional minutes in
excess of the allotted amount in the customers‘ contracts, but the rate per minute is
consistent for all customers with that particular usage plan. In this circumstance, the
telecom entity would likely decide that the option for additional minutes is not providing its
customers with a material right.
Example 9 — option for additional goods that represents a separate performance obligation
A biotech entity may enter into a collaboration arrangement with a pharmaceutical
company whereby the biotech company provides research and development services and
agrees to manufacture a drug for the pharmaceutical company at cost if successful
development and FDA approval is achieved. In this fact pattern, the biotech entity likely
would determine that the option for the pharmaceutical company to receive the
manufactured drug at the biotech entity‘s cost represents a material right. As a result, the
biotech entity would treat that option as a separate performance obligation. Under the
proposed model, the biotech entity would estimate the standalone selling price of that
option, allocate transaction consideration to the option and recognize the revenue when
either the pharmaceutical company exercises the option for discounted manufacturing or
the option expires.
How we see it
Current US GAAP for software revenue recognition (ASC 985-605) addresses some of the
difficulties in distinguishing between (a) an option to acquire goods or services at a
significant discount and (b) a marketing offer. The guidance provides that an offer of a
discount on future purchases of goods or services is presumed to be a separate option in
the contract if that discount is significant and is incremental both to the range of discounts
reflected in the pricing of other elements in that contract and to the range of discounts
typically given in comparable transactions. The guidance in ASC 985-605 is often applied
by analogy to transactions other than software transactions.
Chapter 3: Identify the separate performance obligations in the contract
30 Financial reporting developments The road to convergence: the revenue recognition proposal
Identification of options as separate performance obligations
The proposed guidance explained above is similar to the existing US GAAP guidance in
ASC 985-605. Accordingly, for most transactions, we do not expect significant changes in
practice regarding the identification of an option that represents a material right as a result
of the proposed guidance. However, we do expect a significant change for transactions
including goods or services considered to be contingent deliverables (such as the potential
manufacturing of a drug in Example 9 above). While there is diversity in practice, currently
many entities do not consider these contingent items to be deliverables under the
arrangement. As a result, such contingent items are excluded when the entity is identifying
the deliverables and determining which deliverables are separate units of accounting to
which the transaction consideration is allocated. Under the proposed model, an entity
would have to consider whether these contingent items provide a material right to the
customer (e.g., because of favorable pricing terms on the contingent items).
Measurement of options that are separate performance obligations
The measurement of an option providing a material right, once identified, will differ from
the model currently provided in ASC 985-605. The general principal in ASC 985-605
indicates that a proportionate amount of a significant future discount (i.e., the option)
should be applied to each element within the arrangement (including elements that are not
optional and must be delivered under the contract) based on their relative fair value.
However, if the future elements to which the discount applies are not specified or if vendor-
specific objective evidence (VSOE) of fair value of the future elements does not exist, the
maximum amount of the discount (if quantifiable) must be allocated to the elements in the
arrangement. If the maximum amount of the discount is not quantifiable, the discount rate
is applied to each element in the arrangement.
Example 10 — option for additional software at a discount
A vendor enters into an arrangement to license software products A and B to a customer
for a total of $200. Additionally, the vendor agrees to provide a discount of $30 if the
customer licenses either product C, D or E within a year of the inception of the
arrangement. The VSOE of fair value of both product A and B is $100. The VSOE of fair
value of products C, D and E range from $100 for product C to $400 for product E. The
future discount is more than insignificant.
Chapter 3: Identify the separate performance obligations in the contract
Financial reporting developments The road to convergence: the revenue recognition proposal 31
Under ASC 985-605, the vendor should allocate the discount proportionately based on the
relative VSOE of fair value of products A, B and C (because product C is the lowest possible
fair value of the future purchase on which the discount may be used). The overall discount
rate is 10% ($30 discount divided by the total VSOE of fair value of products A, B and C of
$300). The amount of arrangement consideration allocable to the sale of products A and B
is $180 (the arrangement consideration of $200 reduced by the overall discount of 10%).
The remaining $20 (arrangement consideration of $200, minus the amount allocable to
products A and B of $180) should be recorded as deferred revenue and recognized on the
earlier of the customer‘s purchase of either product C, D or E or the expiration of the
discount period. However, if VSOE did not exist for products C, D or E, ASC 985-605
requires that the maximum amount of the discount, or $30, should be deferred
(i.e., discounting the delivered products by the entire discount amount).
How we see it
However, under the proposed model, the entity treats the option to future discounted
purchases as a separate performance obligation and must determine the estimated
standalone selling price of that option (even in situations in which the future goods and
services to which the discount applies are not specified). Allocation of transaction price to
the option is based on that estimated standalone selling price.
Example 11 — option for additional software at a discount (continued)
Continuing the example above, under the proposed guidance (and consistent with current
practice for multiple-element arrangements other than software), the vendor should
allocate the transaction price to the individual performance obligations within the contract
in proportion to the standalone selling prices of goods underlying each performance
obligation. The amount allocated to the significant and incremental discount would be
recognized in revenue when the performance obligation is satisfied (i.e., when the
customer purchases products C, D or E, or after the option period expires). For example,
the vendor may conclude that the best estimate of selling price for Product A, Product B
and the option to purchase future products at a discount is $100, $100 and $15,
respectively. As a result, the vendor will allocate the total arrangement consideration of
$200 to Product A, Product B and the option on a relative selling price basis, which is $93,
$93 and $14, respectively.
3.6 Sale of products with a right of return
An entity may provide its customers with a right to return a transferred product. Similar to
product warranties, a right of return may be contractual or may be an implicit right that exists
due to the entity‘s customary business practice. A customer exercising their right to return a
product may receive a full or partial refund, a credit applied to amounts owed or applicable to
other goods or services, another product in exchange or any combination thereof.
Chapter 3: Identify the separate performance obligations in the contract
32 Financial reporting developments The road to convergence: the revenue recognition proposal
Offering a right of return in a sales agreement obliges the selling entity to stand ready to
accept a returned product. However, the Boards decided that such an obligation does not
represent a separate performance obligation under the proposed model. Instead, the Boards
concluded that an entity has made an uncertain number of sales when it provides goods with
a return right. That is, until the right of return expires unused, the entity is not certain how
many sales will fail. Therefore, the Boards concluded that an entity should not recognize
revenue for sales that are expected to fail as a result of the customer exercising their rights
to return the goods. This concept is discussed further in Section 6.2.
The Boards point out that exchanges by customers of one product for another of the same
type, quality, condition and price (e.g., one color or size for another) are not considered
returns for the purposes of applying the proposed requirements.
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 33
The proposed guidance defines the transaction price as ―the amount of consideration that an
entity receives, or expects to receive, from the customer in exchange for transferring goods
or services, excluding amounts collected on behalf of third parties (for example, taxes).‖ In
many cases, this is readily determinable as the entity receives payment at the same time it
transfers the promised goods or services and the price is fixed. However, determining the
transaction price may be more challenging when it is variable in amount, when collectibility is
uncertain, when payment is received at a time different from when the entity provides goods
or services or when payment is in a form other than cash. Additionally, consideration paid or
payable to the customer may also affect the determination of transaction price.
An entity recognizes revenue associated with completed performance obligations based on
the estimated transaction price, as long as the entity is able to reasonably estimate the
transaction price. The proposed model indicates that the following conditions must exist in
order for the entity to have the ability to estimate the transaction price:
► The entity has experience with similar types of contracts
► The entity‘s experience is relevant to the contract because the entity does not expect
significant changes in circumstances
An entity‘s experience with similar types of contracts does not have to be its own. For
example, an entity may not have experience with a certain type of contract but its competitor
does. If the entity has access to information about the competitor‘s experience, then the
entity can use the competitor‘s experience as a proxy for its own. However, experience alone
is not enough. That experience, whether an entity‘s own or that of others, must be relevant
to the contract. The circumstances surrounding the current contract should be similar to
those used as the basis of experience. Determining when experience is relevant will be
dependent on the applicable facts and circumstances and will require the use of professional
judgment.
To help with this assessment, Paragraph 39 of the ED specifies factors that, if present, may
suggest that an entity‘s experience is not a sufficient basis for a reasonable estimate.
Excerpt from the ED
39. Factors that reduce the relevance of an entity‘s experience include the following:
(a) the consideration amount is highly susceptible to external factors (for example,
volatility in the market, judgment of third parties and risk of obsolescence of the
promised good or service);
(b) the uncertainty about the amount of consideration is not expected to be resolved
for a long time;
(c) the entity‘ s experience with similar types of contracts is limited; and
(d) the contract has a large number of possible consideration amounts.
Chapter 4: Determine the transaction price
Chapter 4: Determine the transaction price
34 Financial reporting developments The road to convergence: the revenue recognition proposal
An entity‘s assessment of the relevance of its experience is not limited to these factors. Other
factors may exist that indicate an entity‘s experience is not a sufficient basis for a reasonable
estimate. Likewise, the existence of one or more of the above factors would not necessarily
prevent an entity from making a reasonable estimate of the transaction price.
Subsequent changes in the estimated transaction price should be updated at each reporting
period. Expectations about variable consideration should be revised for uncertainties that are
resolved and any new information about remaining uncertainties. Changes to the transaction
price should be allocated to all of the performance obligations in the contract (or contract
segment, see discussion in Section 2.1) so that the cumulative revenue recognized equals what
would have been recognized if the new information had been known at contract inception.
If the entity lacks the ability to make a reasonable estimate, the transaction price is limited to
the amount of consideration that is fixed or that can be reasonably estimated.
4.1 Variable consideration
The transaction price reflects an entity‘s expectations about the consideration it will receive
from the customer. A portion of the transaction price could vary in amount and timing for
such things as discounts, rebates, refunds, credits, incentives, bonuses/penalties,
contingencies or concessions. For example, a portion of the transaction price would be
variable at contract inception if it requires meeting specified performance conditions and
there is uncertainty regarding the outcome of such conditions. Alternatively, a portion of the
transaction price would not be considered variable at contract inception if it is contingent on
the entity‘s delivery of all of the goods and services identified in the contract. For example,
the transaction price would not be considered variable in an arrangement in which an entity is
obligated to provide three pieces of furniture, and the failure to deliver any of those goods
results in a partial refund to the customer for each undelivered piece.
Under the proposed guidance, variable consideration is measured based on a probability-
weighted estimate. Under this approach, the entity‘s estimate identifies the possible
outcomes of a contract and the probabilities of those outcomes. The ED indicates the Boards
believe this approach best reflects how contracts are negotiated and priced. Further, the
Boards believe the probability-weighted approach provides more consistent accounting for
similar contracts than alternative approaches, such as a predictive approach. A predictive
approach would predict the most likely or probable outcome and use that threshold as the
basis for revenue recognition. Under that approach, similar contracts could have different
accounting depending on how closely a contract passes or misses the threshold.
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 35
Example 12 — probability-weighted estimate of expected consideration
A long-term contractor enters into an arrangement that states the contractor will receive a
$100,000 performance bonus if the contractor meets specified performance targets. The
contractor has performed these types of contracts in the past, and has determined it has
the ability to make a reasonable estimate of whether it will earn the performance bonus.
The contractor has determined that it believes it is 80% likely it will receive the entire
performance bonus, and 20% likely it will receive none of the bonus. As a result, the
contractor would include $80,000 [($100,000 x 80%) + ($0 x 20%)], in the transaction
price associated with this potential performance bonus. Comparatively, under current US
GAAP, the contractor would include $100,000 in the transaction price as that reflects the
amount the entity believes it is likely to receive under a predictive approach.
How we see it
For a number of entities, the treatment of variable consideration under the proposed
model will represent a significant change from current practice. While there are certain
exceptions, most current US GAAP limits the amount of revenue recognizable to the
amount that is not contingent upon the satisfaction of performance obligations in the
future. As a result, entities likely will recognize revenue sooner for variable amounts under
the proposed model. However, for certain industries, the proposed model actually may
result in a delay in revenue recognition from current practice.
Example 13 — probability-weighted average estimate accelerates revenue recognition
compared to current practice
A biotech company enters into a collaboration arrangement with a pharmaceutical
company to provide a license of certain intellectual property rights and ongoing research
and development (R&D) activities to further develop those rights. Under the agreement,
the biotech is eligible for two potential milestone payments. The first milestone payment of
$5 million is received upon enrollment of the first clinical patient in phase II clinical trials
and the second milestone payment of $10 million is receive upon FDA approval of a drug
candidate based on the intellectual property.
Chapter 4: Determine the transaction price
36 Financial reporting developments The road to convergence: the revenue recognition proposal
Under current US GAAP, the biotech would not recognize any revenue associated with
those milestone payments until the milestone is achieved. (While there is diversity in
practice as to the amount of revenue recognized upon achievement of the milestone, no
contingent revenue is recognized prior to that point.) Conversely, under the proposed
model the biotech would determine the probability-weighted estimate of the consideration
expected to be received based on the likelihood of performance targets being met (if
reasonably estimable). The probability-weighted estimate of expected milestone payments
would be included in the total transaction price allocated to the performance obligations,
and recognized as those obligations are satisfied. In many cases, that will result in at least
some of the potential milestone payments being included in the estimated transaction
price and recognized in revenue prior to the actual receipt of the milestone payments.
That is, it would be rare that biotech would conclude that the probability of collecting the
associated milestone payment remains at zero or is not reasonably estimable until
immediately prior to collection.
In this example, the biotech may determine at contract inception that the likelihood of
obtaining the first milestone payment is 15%, and that the likelihood of achieving the
second milestone payment is not reasonably estimable. As a result, biotech includes
$750,000 [($5 million x 15%) + ($10 million x 0%)] associated with the milestones in the
total estimated transaction price at the onset of the contract. The total estimated
transaction price is then allocated to the identified performance obligations.
At the end of year one, the entity determines the likelihood of obtaining the first milestone
payment has increased to 60%. The entity will have to adjust the estimated transaction
price by $2,250,000 (or the difference between the current probability-weighted average
estimate of $3 million [($5 million x 60%) + ($10 million x 0%)] compared to the original
estimate of $750,000.
However, during year two, as a result of negative developments in the R&D activities,
biotech determines the likelihood of obtaining the first milestone payment is now zero.
Biotech would have to reduce the estimated transaction price to exclude all amounts
associated with the milestone payments ($3 million) and, to the extent such amounts were
allocated to completed performance obligations, reverse revenue previously recognized.
Example 14 — probability-weighted average estimate delays revenue recognition
compared to current practice
An asset management company (e.g., a hedge fund) has an arrangement with a customer
whereby, under the terms of the arrangement, the asset manager receives a fee of 2% of
the total annual return on the assets in the portfolio. The annual performance is measured
based on the 12-months ended 31 May each year.
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 37
Current US GAAP provides the asset management company an accounting policy election
for the recognition of those performance based fees — one choice allows revenue
recognition prior to the end of the performance period and the finalization of the
performance fee. Therefore, if the funds had earned $20 million as of 31 December, the
asset manager could have recognized $400,000 in revenue if that were the accounting
policy selected.
Conversely, under the proposed model, as the amount of performance fees are not
estimable (i.e., the fees are based in large part on external factors and an entity cannot
estimate how the market will perform over a specific period of time), the asset
management company would not be able to recognize any revenue as of 31 December and
would have to wait until the end of the performance period to recognize those
performance-based fees.
How we see it
Further, the use of a probability-weighted average estimate to determine the amount of
expected contingent consideration is likely a new requirement for many entities currently
applying US GAAP. While certain areas of current guidance require a similar approach to
making an estimate (e.g., fair value determinations for financial instruments, measurement
of an asset retirement obligation), probability-weighted average calculations currently do
not have wide-spread application under US GAAP. Further, these estimates will have to be
updated at each reporting date.
In performing a probability-weighted average estimate, it is unclear how many possible
outcomes an entity is required to consider. While the range of potential outcomes likely
affects this conclusion, an entity will have to use judgment to determine what reasonable
number of possible outcomes (and their likelihood of being achieved) is appropriate.
Finally, under current US GAAP, in situations in which variable payments may be included
in the transaction price, the approach is generally a predictive approach. That is,
management includes what it determines to be its best estimate of the amount to be
received. Comparatively, the use of a probability-weighted average approach will likely
provide different results (which may not be a possible outcome under the contract as
illustrated in the example below).
Chapter 4: Determine the transaction price
38 Financial reporting developments The road to convergence: the revenue recognition proposal
Example 15 — variable consideration
An entity enters into a long-term contract within the scope of ASC 605-35 that includes a
$2 million performance bonus. Under current US GAAP that entity would include in the
total transaction price 100% of the amount that it believes is probable of receipt. Assume
that the entity believes there is 70% likelihood that it will not earn the performance bonus
and a 30% likelihood that it will earn it. Under current practice, the entity would include
zero in its determined transaction price because the receipt of the bonus is not probable.
However, under the proposed model, the entity would include $600,000 [(70% x $0) +
(30% x $2 million)], which is not a possible outcome under the contract. This estimate
would continue to be updated each reporting period. If the entity determines in six months
that it is now 90% likely it will not receive the performance bonus and only 10% likely that it
will, it will reduce the amount of transaction consideration by $400,000. To the extent the
transaction price has been allocated to completed performance obligations, the entity will
recognize a reduction in revenue in that period.
4.2 Collectibility
In determining the transaction price, the entity must also consider the effects of collectibility.
Collectibility refers to a customer‘s credit risk — that is, the customer‘s ability to pay the
amount of promised consideration. In many contracts, the effect of the customer‘s credit risk
is immaterial. For example, in a retail transaction an entity collects the promised
consideration from the customer at the point of sale. The entity would recognize as revenue
the entire amount of promised consideration. However, in some cases, the consideration is
not received at the point of the transfer of the good or service and an entity expects a portion
of their customers to default. In such contracts, the transaction price should reflect the
possibility that the entity will not receive all of the promised consideration, based on a
probability-weighted approach of the potential outcomes. Similar to the requirements for
measuring variable consideration, the proposed model requires that an entity must be able to
make reasonable estimates of collectibility. If it cannot, revenue should be recognized on a
cash basis or once an amount can be reasonably estimated.
Some entities enter into groups of similar contracts. The proposed model permits entities to
aggregate these contracts for purposes of recognizing the effects of collectibility on the
transaction price. An entity could recognize revenue for an individual contract based on its
invoiced amount and reduce the receivable and revenue for the effects of collectibility for the
group of contracts based on the probability-weighted amount of consideration the entity
expects to receive from the pool of contracts.
Any changes in the amounts expected to be collected or actually collected subsequent to the
satisfaction of the related performance obligation are recognized in other income or expense
(i.e., separate from revenue). The Boards decided that this approach was more consistent
with the proposed guidance based on the notion that once the performance obligation is
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 39
satisfied, there should be no changes in the revenue recognized. A reassessment of a
customer‘s credit risk is reflective of an impairment, or reversal of impairment, of the
receivable, resulting in a charge to other income or expense, not revenue. This is similar to
the accounting for noncash consideration received in exchange for a good or service for
which changes in value of the noncash consideration after performance is complete are
recognized outside of revenue.
How we see it
The proposed guidance on collectibility represents a significant change to how all entities
recognize revenue. The proposed model considers collectibility in the measurement of
revenue, while existing standards consider collectibility in the recognition of revenue. SEC
SAB Topic 13, Revenue Recognition, states that revenue can be recognized only if
―collectibility is reasonably assured.‖ As long as collectibility is reasonably assured, entities
recognize as revenue the full amount of promised consideration. Any doubts about a
customer‘s ability to pay are recognized as an allowance for doubtful accounts and bad debt
expense. If collectibility is not reasonably assured, an entity generally recognizes revenue on
a cash basis. As a result, in situations in which an entity determines that there is uncertainty
regarding an individual customer‘s ability to pay, considering collectibilty in the measurement
of revenue likely will result in earlier revenue recognition in those transactions. However, in
situations in which an entity is considering collectibility for a pool of customers the proposed
model is unlikely to have any effect on the timing of revenue recognition.
Additionally, requiring the uncertainty about an entity‘s ability to pay the promised
consideration to be reflected in the measurement of the transaction price, and therefore in
the amount of revenue recognized, will result in a permanent reduction in revenue, which
could be significant for entities that historically have had material bad debts, such as health
care entities. This will affect margins and other key revenue metrics for entities.
Example 16 — adjusting for risk related to collectibility
A vendor sells a piece of machinery for $2,000 and payment is due 45 days after the
machinery is transferred to the customer. The cost of the machinery is $1,500. Based on
its experience with similar contracts, the vendor estimates that there is a 15% probability
that it will not collect the promised consideration. Therefore, the transaction price is
$1,700 [(85% x $2,000) + (15% x $0)]. When the vendor transfers the machinery to the
customer, it recognizes a receivable and revenue of $1,700.
The vendor ultimately receives the full amount of promised consideration of $2,000.
Revenue is not grossed up for the $300 difference [$2,000 - $1,700] between the cash
received and the revenue originally recognized. Instead, the $300 is presented as other
income. Alternatively, if the vendor only receives $1,400, the $300 difference is
presented as other expense.
Chapter 4: Determine the transaction price
40 Financial reporting developments The road to convergence: the revenue recognition proposal
Under current US GAAP, the vendor would recognize a margin of $500 [$2,000 revenue -
$1,500 cost] and, because collection of the receivable is probable, no bad debt expense.
Under the proposed model, the vendor would recognize a margin of $200 [$1,700
revenue - $1,500 cost]. Collections above the amount of revenue recognized would not
improve margins.
How we see it
Measuring the effects of collectibility on the transaction price may be difficult to
implement. An entity may decide that grouping contracts is an easy way to estimate
collectibility for a large number of similar transactions, as illustrated in the following
example:
Example 17 — adjusting for risk related to collectibility (continued)
Continuing the example from above, assume the vendor sells the piece of machinery to
100 customers in April and decides to group these contracts since they have similar
characteristics (same machinery, pricing and terms and conditions of sale). Further,
assume that the vendor expects that, based on a probability-weighted average calculation,
15% of the receivables will prove uncollectible. The vendor records a receivable and
revenue for $200,000 ($2,000 invoiced amount x 100 customers) and a corresponding
reduction to the receivable and revenue of $30,000 to reflect the total consideration
expected to be received of $170,000 ($1,700 transaction price x 100 customers). During
the month of May, 60% of the customers pay in full and 10 customer pay only 70%, so the
vendor collects a total of $134,000 [(60 x $2,000) + (10 x 70% x $2,000)]. Additionally,
the vendor determines it will not collect any of $2,000 outstanding from five customers as
they each filed for bankruptcy during the month. As a result, by the end of May, the vendor
has collected $134,000, has written off $16,000 [(5 x $2,000) + (10 x 30% x $2,000)] as
uncollectible and has $50,000 remaining to be collected. The vendor estimates that of the
remaining $50,000 in uncollected receivables, $20,000 will prove uncollectible. Because
the sum of the $16,000 in receivables written off and the remaining $20,000 not
expected to be collected exceeds the original estimate of uncollectible receivables
($30,000), an allowance for doubtful accounts $6,000 must be recognized as an expense.
4.3 Time value of money
For certain transactions, the timing of the payment does not match the timing of the transfer
of goods or services to the customer (e.g., the consideration is prepaid or is paid well after
the services are provided). When the customer pays in arrears, the entity is effectively
providing a loan to the customer. Conversely, when the customer pays in advance, the entity
has effectively received a loan from the customer. In such situations, the entity would have to
consider the effects of the time value of money on the total transaction amount. If the effect
of the time value of money is material, the transaction price should be adjusted.
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 41
An entity should determine the transaction price by discounting the amount of promised
consideration. It should use the same discount rate that it would use if it were to enter into a
separate financing transaction with the customer, independent of providing other goods or
services. Using the risk-free rate or a rate explicitly stated in the contract that does not
correspond with separate financing rate would not be acceptable. Instead, the discount rate
should reflect the credit characteristics of the parties to the contract. Because this rate would
reflect the customer‘s credit worthiness (i.e., collection risk), an entity should not also adjust
the amount of promised consideration for collectibility.
How we see it
Many entities today do not consider the time value of money because it is not required for
short-term (i.e., one year or less) receivables that arise in the normal course of business.
Determining whether the effect is material will be dependent on the applicable facts and
circumstances and will require the use of professional judgment. The length of time
between payment and transfer of goods or services to the customer is not the only factor
that should be considered. There may be circumstances in which the effect of the time
value of money is material to a short-term contract because, for example, the customer‘s
credit worthiness is poor and a high rate would be used to discount that amounts to be
collected. Additionally, an arrangement may include a financing component even when the
timing of the payment matches the timing of the provision of services.
Example 18 — Arrangement includes financing component
An entity enters into a 3-year supply contract in which it agrees to provide the customer
with 15 pieces of major medical equipment at $1 million per unit. Based on its experience
with similar goods, the entity expects its production cost per unit to decrease over the 3-
year contract due to decreases in the cost of technology. On a standalone basis, the entity
estimates that it would price the product at $1.1 million, $1 million and $0.9 million in
each year, respectively, to reflect the expected cost trend. Effectively, the supplier is
financing any of the units purchased in the first year because the contract price is less than
the standalone selling price.
How we see it
The proposed treatment of the time value of money will likely have the most significant
effect for those transactions involving large pre-payments or payments in arrears. When
an entity receives a large pre-payment, the effect of accounting for the time value of
money in that transaction likely will result in the amount of revenue ultimately recognized
exceeding the consideration received. Conversely, transactions that provide for significant
payments in arrears likely will result in less revenue being recognized than the
consideration received.
Chapter 4: Determine the transaction price
42 Financial reporting developments The road to convergence: the revenue recognition proposal
Determining a customer-specific discount rate could be the most challenging aspect in
determining the effect of the time value of money on the transaction price. The proposed
guidance requires that the discount rate used be a rate similar to what the entity would
have used in a separate financing transaction with the customer. As most entities are likely
not in the business of entering into freestanding financing arrangements with their
customers, they may find it difficult to identify an appropriate rate to use. However, most
entities perform some level of credit analysis before financing purchases for a customer, so
the vendor will have some information about credit risk of the customer. For entities that
have differential pricing for products depending on the time of payment (e.g., cash
discounts), the proposed guidance indicates that the appropriate discount rate could be
determined by identifying the rate that discounts the nominal amount of the promised
consideration to the cash sales price of the good or service.
The financing component of a contract should be presented separately from the revenue
recognized. An entity would recognize the discounted promised consideration as revenue.
The financing component is recognized as interest expense (when the customer pays in
advance) or interest income (when the customer pays in arrears). The interest income or
expense is recognized over the financing period using the interest method described in
ASC 835, Interest.
4.4 Noncash consideration
Customer consideration might be in the form of goods, services or other noncash
consideration. When an entity receives, or expects to receive, noncash consideration, the
transaction price is equal to the fair value of the noncash consideration9. An entity would
apply the principles of ASC 820 in measuring the fair value of the noncash consideration. If
an entity cannot reasonably estimate the fair value of noncash consideration, it should
measure the noncash consideration indirectly by reference to the selling price of the
promised goods or services.
In some transactions, a customer contributes goods or services, such as equipment or labor,
to facilitate the fulfillment of the contract. If the entity obtains control of the contributed
goods or services, it should consider them noncash consideration and account for that
consideration as described above.
9 This statement applies only to transactions that are in the scope of the proposed guidance.
Nonmonetary exchanges between entities in the same line of business that are arranged to
facilitate sales to third parties (i.e., the entities involved in the exchange are not the end consumer)
are excluded from the scope of the proposed guidance.
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 43
How we see it
The concept of accounting for noncash consideration at fair value is consistent with
current US GAAP. However, under current US GAAP, an entity would first look to the fair
value of the goods or services surrendered and then to the fair value of the asset acquired
if it were more clearly evident. Under the proposed model, the order is reversed. An entity
first measures noncash consideration at the fair value of the goods or services received
and only looks to the fair value (i.e., selling price) of the goods or services surrendered if
the fair value of the goods or services received is not reasonably estimable. We would not
expect this nuance to have a significant effect on the measurement of noncash
consideration for most entities.
4.5 Consideration paid or payable to a customer
Many entities make payments to their customers from time to time. In some cases, the
consideration paid or payable represents purchases by the entity of goods or services offered
by the customer that satisfy a business need of the entity. In other cases, the consideration
paid or payable represents incentives given by the entity to entice the customer to purchase,
or continue purchasing, its goods or services.
Consideration paid or payable to customers commonly takes the form of discounts, coupons,
free products or services and equity instruments, among others. In addition, some entities
will make payments to the customers of resellers or distributors that purchase directly from
the entity (e.g., manufacturers of breakfast cereals commonly offer coupons to the
consumers of their products, although the manufacturer‘s direct customers are the grocery
stores that sell to the consumers). Other common forms of consideration paid or payable to
customers include the following:
► Slotting fees, in which a vendor provides consideration to a reseller to ―obtain space‖ for
the vendor‘s products on the reseller‘s store shelves, whether those shelves are physical
(i.e., in an actual building in which the store is located) or virtual (i.e., they represent
space in an internet reseller‘s online catalog)
► Cooperative advertising arrangements, in which a vendor agrees to reimburse a reseller
for a portion of costs incurred by the reseller to advertise the vendor‘s products
► Buydowns or price protection, in which a vendor agrees to reimburse a retailer up to a
specified amount for shortfalls in the sales price received by the retailer for the vendor's
products over a specified period of time
► Coupons and rebates, in which an indirect customer of a vendor may receive a return of a
portion of the purchase price of the product or service acquired by returning a form to
the retailer or the vendor
Chapter 4: Determine the transaction price
44 Financial reporting developments The road to convergence: the revenue recognition proposal
In order to determine the appropriate accounting, an entity must first determine whether the
consideration paid or payable to a customer is:
► A reduction of the transaction price
► A payment for a distinct good or service
► A combination of both
If the consideration paid or payable to a customer is a discount or refund for goods or
services provided to a customer, an entity should reduce the transaction price, and thus
revenue, by the amount paid or payable to the customer. This reduction should be recognized
at the later of when the entity transfers the promised goods or services to the customer or
the entity promises to pay the consideration, even if the payment is conditional on a future
event. If the consideration paid or payable to a customer includes variable consideration, an
entity would measure the reduction of the transaction price using the probability-weighted
approach (see Section 4.1 for further discussion). Further, the promise to pay the
consideration might be implied by the entity‘s customary business practice. For example, if
goods subject to a discount through a coupon are already on the shelves of retailers, the
discount would be recognized when the coupons are issued. However, if a coupon is issued
that can be used on future purchases of products that have not yet been sold to retailers, the
discount would be recognized upon sale to a retailer.
If the consideration paid or payable to a customer includes variable consideration such as
volume discounts, an entity would measure the reduction of the transaction price using the
probability-weighted approach (see Section 4.1 for further discussion). Further, the promise
to provide the discounts might be implied by the entity‘s customary business practice.
If the consideration paid or payable to a customer is in exchange for distinct goods or
services received from the customer, than an entity should account for the goods or services
received in the same way as any other purchases in the normal course of business. In other
words, the goods or services would be capitalized or expensed in accordance with other
US GAAP, rather than a reduction in revenue. An entity should use the same criteria to
determine whether a good or service is distinct as described earlier with respect to
identifying performance obligations.
In some cases, the amount of consideration received from the customer and any payment of
consideration to that customer could be linked, yet the vendor could also receive distinct
goods or services. For instance, a customer may pay more for goods or services than it would
otherwise have done if it was not receiving a payment from the entity for other goods or
services provided by the customer. This situation is treated as both a reduction in the
transaction price and payment for a distinct good or service. Under the proposed model, the
entity determines the fair value of the good or service it received from the customer and
compares it to the consideration payable to the customer. Any excess of the consideration
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 45
payable over the fair value of the distinct goods or services received would reduce the
transaction price. If the entity cannot reasonably estimate the fair value of the good or
service received from the customer, the entity should account for the entire consideration
payable to the customer as a reduction of the transaction price.
How we see it
Generally, the accounting for consideration payable to a customer under the proposed
model is consistent with current US GAAP. However, the determination of whether a good
or service is ―distinct‖ under the proposed model may differ from the current
determination under US GAAP of whether the vendor has received an ―identifiable
benefit.‖ For example, under current US GAAP, slotting fees are generally treated as a
reduction of revenue for the reasons described in the following paragraph. However, under
the proposed model as illustrated in Example 23 of the ED, slotting fees could be treated as
a payment for a distinct good or service, and therefore recognized as expense, or a
combination of a reduction in revenue and a payment for a distinct good or service.
Slotting fees generally are characterized as a reduction of revenue under current US GAAP
because they do not meet the identifiable benefit criteria. In order to meet this condition,
the identified benefit must be sufficiently separable from the recipient's purchase of the
vendor's goods such that the vendor could have entered into an exchange transaction with
a party other than a purchaser of its goods or services in order to receive that benefit.
Although a slotting fee may provide the vendor with an identifiable benefit in the form of
an exclusive right to provide a particular good to a retailer or reseller, the vendor could not
obtain such a benefit separately from the sale of its goods to the customer.
Conversely, as described earlier, the proposed guidance states that a good or service is
distinct if it is sold separately or could be sold separately because it has a distinct function
and profit margin. While a slotting fee is not sold separately, the illustrative guidance in the
ED indicates that the fee is for a distinct service (stocking, displaying and supporting the
products). As a result, the entity may determine the services has a distinct function (it has
utility together with the related goods or services) and a distinct profit margin (it is subject
to distinct risks and the entity can separately identify the resources needed to provide the
slotting fees). If an entity reached that conclusion, it would be a change from the current
accounting for those fees.
4.6 Nonrefundable upfront fees
In certain circumstances, entities may receive payments from customers in advance of
rendering a contracted service or delivering a good. Upfront fees generally relate to the
initiation, activation or set up of a good to be used or a service to be rendered in the future.
Upfront fees also may be paid to grant access to or a right to use a facility, product or
service. In many cases, the upfront amounts paid by the customer are nonrefundable.
Common examples of upfront fees are fees paid for membership to a health or buying club
and activation fees for phone, cable or internet usage.
Chapter 4: Determine the transaction price
46 Financial reporting developments The road to convergence: the revenue recognition proposal
Entities must evaluate whether nonrefundable upfront fees relate to the transfer of a good or
service. In most situations, the upfront fee would not have been paid without continuing use
of the good or service. Therefore, the fee does not relate to the actual transfer of a good or
service. Instead, the upfront fee is an advance payment for future goods or services.
Consequently, the upfront fee should be recognized as revenue when the future goods or
services are transferred to the customer. The period of recognition of the upfront fee should
include optional renewal periods to the extent that the renewal option is a material right (see
discussion in Section 3.5 for further discussion on renewal options).
There may be some situations in which an entity determines that a nonrefundable upfront fee
does relate to the transfer of a good or service. In this case, the entity will need to determine
if the good or service associated with the nonrefundable upfront fee is a separate
performance obligation.
How we see it
It is unclear whether the proposed guidance will result in a significant change in practice.
Under current practice, an upfront fee generally is recognized over the longer of the
contractual period or the expected customer relationship period.
Under the proposed guidance, when a transaction includes a non-refundable up-front fee,
entities will need to carefully analyze not only whether there is a distinct up-front
performance obligation associated with that fee, but also whether it indicates there are
other performance obligations in the contract that should be identified. For example, the
proposed model indicates that the existence of such a fee may provide the customer with
the ability to get future services at a discounted rate. In many transactions a customer
pays an up-front fee as part of entering into a contract. However, the customer can renew
the contract each year without paying the up-front fee again, which may indicate that the
entity has provided the customer with an option to purchase discounted services in the
future. Even in situations in which the entity determines that an option has been provided,
the period to which the option relates (and therefore the period over which the allocated
revenue would be recognized) is not necessarily the same as the contractual period or
expected customer relationship period.
Chapter 4: Determine the transaction price
Financial reporting developments The road to convergence: the revenue recognition proposal 47
Example 19 — non-refundable up-front fees
A customer signs a one-year contract with a health club and is required to pay both a
nonrefundable upfront membership fee of $150 and monthly fees of $40. The club‘s
activity of registering the customer does not transfer any service to the customer and,
therefore, is not a performance obligation. The club does have an obligation to keep the
health club open and available for use to the customer. Additionally, by not requiring that
the customer pay the membership fee again at renewal, the club is effectively providing a
discounted renewal rate to the customer. The club determines that renewal option is not
material and is not a separate performance obligation. The $150 membership fee is
allocated to the performance obligation to provide access to the health club and
recognized as revenue over the one-year contract period.
Alternatively, the club may determine the renewal option is material and is a separate
performance obligation. Based on historical experience, the club determines that its
customers, on average, renew their annual memberships two times before terminating
their relationship with the club. As a result, the club determines that the option provides
the customer the right to two annual renewals at a discounted price. In this scenario, the
club would allocate the total transaction consideration of $630 ($150 upfront membership
fee + $480 ($40 x 12 months) to the two identified performance obligations (monthly
service and renewal option) based on the relative standalone selling price method. The
amount allocated to the renewal option would be recognized as each of the two renewal
periods is either exercised or forfeited by recognizing 50% of the transaction price
allocated to the renewal option at the end of year one, and 50% at the end of year two.
This pattern of revenue recognition for this type of upfront fee is significantly different
than the pattern used under current US GAAP, in which the upfront fee would be
recognized ratably over the expected customer relationship period of three years.
Chapter 5: Allocate the transaction price to the separate performance obligations
48 Financial reporting developments The road to convergence: the revenue recognition proposal
Once the performance obligations are identified and the transaction price has been
determined, the proposed model requires an entity to allocate the transaction price to the
performance obligations in proportion to their standalone selling prices (i.e., on a relative
standalone selling price basis). Any discount within the contract is allocated proportionally to
all of the separate performance obligations in the contract.
How we see it
The required use of the relative standalone selling price basis will be a significant change in
accounting for many transactions, including those transactions that were accounted for
using the residual method (see Section 5.1 for further discussion of the residual method).
Additionally, this requirement, combined with the change in treatment of variable
consideration under the proposed model (discussed in Section 3.1), likely will have a
significant effect on those transactions in which the amount of revenue recognizable is
limited under current US GAAP due to contingencies associated with the transaction
consideration. In most of these situations, the relative standalone selling price method will
result in earlier revenue recognition.
Example 20 — relative selling price allocation
Wireless Company offers its customers a 400 minute wireless plan for $40 a month over a
2-year contract period, which is also the standalone selling price of this plan. Wireless
Company offers two handsets: a cell phone model that has been in the market for 18
months that the operator is offering for free (standalone selling price is $200) and the
newest version of the phone that includes improved features and functionality for which
the operator is charging $160 (standalone selling price is $480). For purposes of this
example, assume the standalone selling price of the 400-minute wireless plan is $40.
Customer A selects the older model cell phone, and Customer B selects the newer model.
Wireless Company does not expect any credit loss, and no rebates, incentives or other
discounts are provided.
The following table illustrates the differences in the allocation of the transaction price and
revenue recognized between current US GAAP and the proposed model:
Current US GAAP Proposed model
Customer A Customer B Customer A Customer B
Handset revenue
$ – $ 160 $ 166 $ 373
[Free — no cash received] [$160 cash received] [$200/(960+200)x960] [$480/(960+480)x1,120]
Service revenue
960 960 794 747
[$40/month x 24 months] [$40/month x 24 months] [$960/(960+200)x960] [$960/(960+480)x1,120]
Total revenue $ 960 $ 1,120 $ 960 $ 1,120
Chapter 5: Allocate the transaction price to the separate performance obligations
Chapter 5: Allocate the transaction price to the separate performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 49
Under current US GAAP, the telecom operator is limited to recognizing revenue upon the
delivery of the handset to the amount of consideration received up front; that is, the
discounted purchase price. When the phone is provided at no charge, the telecom operator
is prevented from recognizing any revenue upon the delivery of the handset. This is because
the remaining transaction consideration generally is contingent upon the telecom operator
providing the monthly wireless service and, therefore, cannot be allocated to the first
delivered item. Conversely, under the proposed model, the total transaction consideration is
allocated to the identified deliverables (handset and monthly service) on the relative
standalone selling price, and revenue recognized is with each performance obligation as
that performance obligation is satisfied. The end result is that the telecom operator will
allocate some of the transaction consideration to the handset, and recognize that revenue
before the consideration is actually due from the customer.
5.1 Estimating standalone selling prices
Under the proposed model, the standalone selling price should represent the price an entity
would sell a good or service on a standalone basis at contract inception. When available, the
proposed model indicates the observable price of a good or service sold separately provides
the best evidence of standalone selling price. However, in many situations, standalone selling
prices will not be readily observable. In such situations, the entity must estimate the amount
for which it would sell each performance obligation on a standalone basis.
The proposed model is clear that an entity should not presume that a contractually stated
price or a list price for a good or service is representative of the standalone selling price. For
example, a vendor enters into a contract with Customer A to provide good A at $100, good B
at $75, and good C for free. In order to allocate the transaction price appropriately, the
vendor will have to determine the standalone selling prices for each of the goods and not
simply use the rates stated in the contract.
How we see it
Multiple-element transactions
The relative standalone selling price method required for allocation under the proposed
model is similar to the relative selling price method required under ASC 605-25 (after
reflecting the effects of ASU 2009-13), which provides a hierarchy to follow in determining
the standalone selling price that includes VSOE, third-party evidence (TPE) and best
estimate of selling price. While the proposed model does not specify a hierarchy, it
indicates that the use of observable inputs should be maximized. Accordingly, we would
not expect significant differences in estimated selling prices to arise between the proposed
model and the recently amended revenue recognition guidance.
Chapter 5: Allocate the transaction price to the separate performance obligations
50 Financial reporting developments The road to convergence: the revenue recognition proposal
However, for those entities that have not yet adopted the provisions of ASU 2009-13, it does represent a significant change from the existing guidance within ASC 605-25. Based
on experiences from early adopters of ASU 2009-13, entities may find implementing the relative standalone selling price method difficult. First, developing the estimated selling price for elements that are not typically sold separately is challenging. Second, entities are
facing information systems challenges. Certain legacy information systems do not have the functionality required to apply the relative selling price method and, as a result, many early adopters have been using spreadsheets and databases to make necessary adjustments.
Software transactions
Transactions currently accounted for under the software revenue recognition guidance will
be significantly affected by the allocation guidance. Oftentimes, VSOE of selling price does not exist for all of the elements in a software arrangement and, therefore, the use of the residual method (described in the next paragraph) is prevalent. In fact, in many situations,
VSOE does not exist for any of the undelivered elements and results in the full deferral of revenue on the delivered elements.
Under the residual method, the amount of arrangement consideration allocated to the undelivered elements is equal to the VSOE of selling price of those elements. The amount
allocated to the delivered elements is equal to the difference between the total arrangement consideration and the selling price allocated to the undelivered elements, or the ―residual‖ arrangement consideration. The use of the residual method results in the
entire discount included in the arrangement being allocated to the delivered elements. Under current US GAAP, software vendors generally apply the residual method to allocate arrangement consideration to software licenses as such licenses are rarely, if ever, sold separately (accordingly, VSOE of selling price cannot exist for the software license).
Under the proposed model, the residual method is prohibited and software vendors will be required to estimate the standalone selling price of software licenses such that the transaction price may be allocated to all of the performance obligations included in the
contract, including the software license, based on their relative standalone selling prices. Entities may find it difficult to determine the standalone selling prices of licenses as a result of the current business practices within that industry. Generally, the software license is the
element of the arrangement that reflects pricing fluctuations, while services and postcontract customer support (PCS) are priced consistently from arrangement to arrangement. Although the ED provides the flexibility to use a cost-plus approach to
estimate the standalone selling price (see below), the lack of incremental cost associated with the sale of a software license may require the exercise of greater judgment in pricing each transaction as compared to companies that sell tangible products.
Further, as described in Section 3.1 a good or service must be ―distinct‖ to be considered a
separate performance obligation. If an entity lacks the ability to identify the costs or distinguishable resources needed to provide the license, a distinct profit margin would likely not be evident for those licenses, resulting in the entity‘s inability to demonstrate that
a software license is distinct.
Chapter 5: Allocate the transaction price to the separate performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 51
Example 21 — distinct goods and services
A software vendor provides a customer a non-exclusive perpetual software license and
PCS services for a term of one year, with the option to renew PCS on an annual basis. The
software vendor determines that VSOE of selling price of PCS does not exist; however,
50% of actual PCS renewals were within a narrow range of pricing. Because VSOE of selling
price does not exist, the vendor would have to defer recognition of the license fee under
current US GAAP. Under the proposed model, the software vendor‘s analysis of PCS
renewals will help support its estimate of the standalone selling price of the PCS. However,
the vendor will have to determine whether or not the software is distinct from the PCS.
If the vendor determines that the software is distinct, it would determine the estimated
standalone selling price of the software and allocate the total transaction consideration to
the two performance obligations (software and PCS) using the relative selling price
method. Once it has allocated the transaction price to each performance obligation, the
entity would determine the appropriate period over which to recognize the revenue. While
the transaction price allocated to the PCS would likely be recognized over the service
period, the entity would have to consider the terms of the software license agreement to
determine the appropriate recognition period (see Section 6.4 for further discussion).
Conversely, the entity may determine that the software is not distinct from the PCS.
This may be the case if the entity cannot identify distinguishable costs or resources
needed to provide the license from those used to provide the PCS (such as the when-and-
if-available upgrades). In such cases, the entity would conclude that the arrangement
contains only a single performance obligation and that the revenue should be recognized
over the PCS period.
If an entity determines that the software is not distinct from the PCS, and that the two
items represent a single performance obligation, the entity may also have to consider
whether any payment received relating to the license is, in fact, an up-front fee that has to
be separately evaluated under the proposed model. If the license is not a separate
performance obligation from the PCS, an entity might conclude that the customer is
receiving not only the software and PCS, but an option to renew that PCS at a discounted
rate (as the upfront license fee is not due each year). Such a conclusion would require the
entity to allocate some of the transaction price to the option, and recognize that amount
over the expected option period.
Chapter 5: Allocate the transaction price to the separate performance obligations
52 Financial reporting developments The road to convergence: the revenue recognition proposal
The proposed model indicates that two possible approaches to estimating standalone selling
price include the following:
► Expected cost plus a margin approach — an entity will use its expected costs of satisfying
the performance obligation and add a margin that the entity typically requires for the
provision of similar goods and services.
► Adjusted market assessment approach — an entity can examine the market in which it
regularly sells goods and services and estimate the price that customers would be willing
to pay. This approach may also include referring to quoted prices from the entity‘s
competitors, adjusted as appropriate to reflect the entity‘s own costs and margins.
The approaches discussed in the proposed model are not the only estimation methods
permitted. The proposed model does not preclude nor prescribe any particular method for
estimating standalone selling prices. Any reasonable estimation method is permitted, as long
as it is consistent with the basis of a standalone selling price, maximizes the use of observable
inputs and is applied on a consistent basis for similar goods and services and customers.
How we see it
In most instances, entities will be able to make estimates of standalone selling prices that
represent management‘s best estimate considering observable inputs. However, there may
be occasions when it is difficult for entities to determine a standalone selling price,
particularly as it relates to the selling price of certain goods or services that are never sold
independently by the entity or others (e.g., specified upgrade rights for software
companies). In these situations, under the proposed model entities still will be required to
make an estimate of the standalone selling price, and may look to the underlying costs or
the target margins for the product. With the exception of those entities that have already
adopted the provisions of ASU 2009-13, which modified ASC 605-25, this will be a
significant change from current practice. This change may require the involvement of
personnel that have not traditionally been involved in determining whether items included
in a multiple-element arrangement can be accounted for separately, such as operating
personnel involved in an entity‘s pricing decisions.
While the proposed guidance seems to indicate that an entity can use either an expected
cost plus a margin approach or an adjusted market approach, we believe that an entity
actually will have to consider both of these approaches in coming up with their estimate of
a standalone selling price. That is, an entity could not determine that the expected cost
plus a margin represents a reasonable standalone selling price if the market would not
support the amount of margin used by the entity.
Chapter 5: Allocate the transaction price to the separate performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 53
Example 22 — estimated selling price
Manufacturing Co. enters into a contract with a customer to sell a machine for $100,000.
The total contract price includes installation of the machine and a two-year warranty.
Manufacturing Co. routinely sells the machine for $75,000 on a standalone basis without
installation or warranty provisions. While Manufacturing Co. rarely provides installation
services separate from the sale of the machines, it is aware that other companies in the
marketplace provide this service, charging $10,000 to $15,000 for each installation.
Manufacturing Co. does not sell warranties separately, nor does anyone else in the
marketplace sell a similar warranty. However, given the length of the warranty,
management has concluded that the objective of the warranty is to cover problems arising
after the machinery is shipped and installed for the customer and, therefore, represents a
separate performance obligation.
In this example, Manufacturing Co. regularly sells the machine on its own and therefore
has evidence of a standalone selling price of $75,000. Management concludes they will
use an adjusted market assessment approach for the installation services using the
competitors‘ mid-point pricing of $12,500, adjusted for Manufacturing Co.‘s cost structure
and expected margin, resulting in an estimated selling price of $14,000. Lastly, the
warranty services are priced based on Manufacturing Co.‘s estimated cost plus a margin,
taking into consideration the amount of margin the market will bear. This estimate results
in a standalone selling price of $20,000 for the warranty.
The aggregate individual standalone selling price ($109,000) exceeds the total transaction
price and must be allocated based on the relative standalone selling price of each
performance obligation. Therefore, the amount of the $100,000 transaction price is
allocated to each performance obligation as follows:
► • Machine — $68,800 ($75,000 × ($100,000/$109,000))
► • Installation — $12,850 ($14,000 × ($100,000/$109,000))
► • Warranty — $18,350 ($20,000 × ($100,000/$109,000))
The entity would recognize revenue as each performance obligation is satisfied in the
amount allocated to that performance obligation at contract inception.
5.2 Changes in transaction price subsequent to contract inception
Under the proposed model, the standalone selling price is determined only at contract
inception. While the amounts allocated to performance obligations are updated to reflect
changes in the estimated transaction price as goods and services are delivered, the
standalone selling prices used to perform the allocation are not updated to reflect changes in
the standalone selling prices after contract inception.
Chapter 5: Allocate the transaction price to the separate performance obligations
54 Financial reporting developments The road to convergence: the revenue recognition proposal
Example 23 — Changes in transaction price
Continuing Example 22 above for Manufacturing Co., assume that after Manufacturing Co.
delivers the machine, the customer is not happy with the performance of the machine and
requests a price reduction of $10,000. Additionally, as a result of the performance issues
highlighted by the customer, Manufacturing Co. estimates its costs to satisfy the warranty
obligation will increase by 15%.
Manufacturing Co. agrees to reduce the price of the transaction by 10%, and must re-
perform the relative selling price allocation, allocating the revised transaction price of
$90,000 to the three performance obligations in the arrangement. However, in doing this
re-allocation, Manufacturing Co. does not update the original standalone selling prices,
despite the expected change in costs associated with the warranty obligation. Therefore,
the amount of the $90,000 transaction price is reallocated to each performance obligation
as follows:
► Machine — $61,926 ($75,000× ($90,000/$109,000))
► Installation — $11,560 ($14,000× ($90,000/$109,000))
► Warranty— $16,514 ($20,000 × ($90,000/$109,000))
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 55
Under the proposed model, an entity recognizes revenue only when an identified
performance obligation is satisfied by transferring a promised good or service to a customer.
A good or service is generally considered to be transferred when the customer obtains
control, which the proposed guidance defines as ―an entity‘s ability to direct the use of, and
receive the benefit from, the good or service.‖ Control would also include the ability to
prevent other entities from directing the use of, and receiving the benefit from, a good or
service. For purposes of applying the proposed model, the transfer of control to the customer
represents the transfer of all rights with regard to the good or service. Upon transferring
control, the customer has sole possession of the right to use the good or service for the
remainder of its economic life or to consume the good or service in its own operations. The
customer‘s ability to receive the benefit from the good or service is represented by its right to
substantially all of the cash inflows, or the reduction of cash outflows, generated by the
goods or services.
Certain transactions are structured so that the selling entity retains a security interest in the
goods subject to the sales contract. For example, a selling entity often retains certain rights
(e.g., legal title) to goods provided to a customer as protection against the customer‘s failure
to pay for the goods. The ED concludes that such rights are protective rights that do not
preclude the customer from obtaining ―control‖ as described in the proposed guidance.
In many situations, the determination of when the customer obtains control is relatively
straightforward. However, in other circumstances this determination is more complex. In an
effort to help entities determine whether a customer has obtained control of a particular
good or service, the Boards have provided certain indicators in Paragraph 20 of the ED.
Excerpt from the ED
30. An entity shall assess the transfer of control of goods or services for each separate
performance obligation. Indicators that the customer has obtained control of a good or
service include the following:
(a) the customer has an unconditional obligation to pay — if a customer is
unconditionally obliged to pay for a good or service, typically that is because the
customer has obtained control of the good or service in exchange. An obligation to
pay is unconditional when nothing other than the passage of time is required
before payment is due.
(b) the customer has legal title — legal title often indicates which party has the ability
to direct the use of, and receive the benefit from, a good. Benefits of legal title
include the ability to sell a good, exchange it for another asset or use it to secure or
settle debt. Hence, the transfer of legal title often coincides with the transfer of
control. However, in some cases, possession of legal title is a protective right and
may not coincide with the transfer of control to a customer.
Chapter 6: Satisfaction of performance obligations
Chapter 6: Satisfaction of performance obligations
56 Financial reporting developments The road to convergence: the revenue recognition proposal
(c) the customer has physical possession — in many cases, physical possession of a
good gives the customer the ability to direct the use of that good. In some cases,
however, physical possession does not coincide with control of a good. For
example, in some consignment and sale and repurchase arrangements, an entity
may have transferred physical possession but retained control of a good.
Conversely, in some bill-and-hold arrangements, the entity may have physical
possession of a good that the customer controls.
(d) the design or function of the good or service is customer-specific — a good or
service with a customer-specific design or function might be of little value to an
entity because the good or service lacks an alternative use. For instance, if an
entity cannot sell a customer-specific asset to another customer, it is likely that the
entity would require the customer to obtain control of the asset (and pay for any
work completed to date) as it is created. A customer‘s ability to specify only minor
changes to the design or function of a good or service or to choose from a range of
standardized options specified by the entity typically would not indicate a
customer-specific good or service. However, a customer‘s ability to specify major
changes to the design or function of the good or service would indicate that a
customer obtains control of the asset as it is created.
The ED acknowledges that some of the indicators may not be relevant to certain transactions.
Additionally, none of the indicators are meant to be individually determinative of whether the
customer has gained control of the good or service.
Revenue is recognized when control of a promised good or service has been transferred to
the customer. For example, if the arrangement involves a promised good (except for certain
customized goods), the entity likely would recognize revenue once the good is transferred to
the customer. Alternatively, if the arrangement involves services, the related revenue likely
would be recognized as the services are provided (based on the notion that control over
those services transfers continuously). These concepts are explored further in the following
sections that discuss some of the complicating terms and conditions prevalent in many
arrangements.
How we see it
Existing US GAAP generally considers the transfer of the risks and rewards of ownership
when determining whether an asset has been transferred (and, thus, when revenue is
recognized). This concept is based on how the seller and the customer share both the
potential gain (the reward) and the potential loss (risk) associated with owning a product.
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 57
The use of a revenue recognition approach based on the risks and rewards of ownership
may often yield similar results to an approach based on control because the party
controlling an asset often has substantially all of the risks and rewards associated with that
asset. However, the Boards concluded that a control approach was the most appropriate
approach for recognizing revenue. In the Boards‘ view, the transfer of goods and services
can be more consistently evaluated when considering control because it can be difficult to
judge whether the preponderance of the risks and rewards have been transferred when the
seller retains some risks and rewards. For example, any risks or rewards retained by a
seller may represent a separate performance obligation under the concept of control
(i.e., a portion of the revenue may be recognized on satisfied performance obligations
apart from the retained risks and rewards). Considering the risks and rewards of
ownership, however, may lead an entity to conclude a single performance obligation exists
that is not satisfied until the risks and rewards are transferred to the customer. This
approach is similar to the control concept used to determine when a financial asset has
been transferred under the guidance for transfers of financial assets in ASC 860.
6.1 Continuous transfer of goods and services
Services arrangements and certain other supply or long-term contracting agreements may
provide for the continuous delivery of goods or services over the course of the contract
period. In many circumstances, the four indicators provided by the Boards (discussed directly
above) to help determine when control has transferred will be evident in situations in which
an entity determines that control transfers continuously.
Example 24 — continuous transfer of control
An entity enters into an agreement to provide for the design and construction of a
specialized piece of equipment. During the design phase, the entity works extensively with
the customer to configure the customized equipment to the customer‘s wishes. The
customer obtains control of the equipment as it is constructed, and makes non-refundable
payments to the entity. In this scenario, the entity determines it has two performance
obligations, the design services and the construction services. Further, the entity
determines that control over both of these obligations transfers continuously.
If the entity is unable to demonstrate that control transfers continuously, the presumption is
that the contract is to provide a completed asset to the customer, in which case revenue is
recognized when control of the completed asset is transferred (generally upon delivery of the
completed asset).
Chapter 6: Satisfaction of performance obligations
58 Financial reporting developments The road to convergence: the revenue recognition proposal
When it has been determined that control transfers continuously, the proposed guidance
requires that the entity select a single revenue recognition method for the relevant
performance obligation that best depicts this continuous transfer. The performance
obligation would be accounted for under the selected method until it has been fully satisfied.
The proposed guidance also states that the selected method is applied to similar
arrangements containing similar performance obligations.
Paragraph 33 in the ED provides three methods for recognizing revenue on arrangements
involving the continuous transfer of goods and services.
Excerpt from the ED
33. Suitable methods of recognizing revenue to depict the continuous transfer of goods or
services to the customer include the following:
(a) output methods that recognize revenue on the basis of units produced or
delivered, contract milestones, or surveys of goods or services transferred to date
relative to the total goods or services to be transferred. Output methods often
result in the most faithful depiction of the transfer of goods or services. However,
other methods may also provide a faithful depiction but at a lower cost.
(b) input methods that recognize revenue on the basis of efforts expended to date (for
example, costs of resources consumed, labor hours expended, and machine hours
used) relative to total efforts expected to be expended. Inputs often are more
directly observable than outputs. However, a significant drawback of input
methods is that there may not be a direct relationship between the efforts
expended and the transfer of goods or services because of deficiencies in the
entity‘s performance or other factors. When using an input method, an entity shall
exclude the effects of any inputs that do not depict the transfer of goods or
services to the customer (for example, the costs of abnormal amounts of wasted
materials, labor, or other resources to fulfill the contract).
(c) methods based on the passage of time. An entity would recognize revenue on a
straight-line basis over the expected duration of the contract if services are
transferred evenly over time.
How we see it
We expect the proposed standard to have a significant impact on some entities that enter
into arrangements to provide goods and services over time. In particular, entities engaged
in construction, software development and other similar activities may see significant
changes in the timing and amount of revenue recognition based on the terms of the
contracts underlying each transaction.
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 59
Example 25 — changes from current practice even when control transfers continuously
Entity G enters into contracts to provide its customer 10 vessels and currently uses a
percentage-of-completion method based on a cost-to-cost measure under ASC 605-35.
That is, it recognizes revenue at each reporting period based on the ratio of costs incurred
to date compared to total costs expected under the contract. However, under the proposed
model, Entity G determines that each of the vessels represents a separate performance
obligation within the contract, and that control over each vessel is transferred as the entity
transfers the vessel to the customer. As a result, Entity G would recognize revenue only as
it delivers each unit, rather than continuously as it would under current US GAAP. For
example, assume at 31 December, the entity believed the contract was 47% complete
based on the costs incurred to date. However, at that point in time, the entity had only
delivered 4 of the 10 vessels. Under current US GAAP, the entity would have recognized
47% of the transaction price as revenue, based on the proportion of costs incurred to date
to total expected costs to construct the vessels. Under the proposed model, the entity
would have recognized only 40% of the total transaction price as revenue.
Further, entities currently using a percentage-of-completion method may determine that
control over certain performance obligations within the contract are transferred at a point
in time (rather than over a period of time) while control over other performance
obligations within the contract are transferred continuously over time. Conversely, under
current US GAAP, once a contract qualifies for the use of the percentage-of-completion
method, generally the entire contract is accounted for under that method.
Example 26 — only certain goods and services within an arrangement are transferred
continuously
Software Co. enters into an arrangement to provide its customer hardware, customized
software and ongoing support services. In analyzing the arrangement, Software Co.
determines that the hardware, customized software and ongoing support each represent
separate performance obligations. Further, the entity concludes that the control of the
hardware transfers at the time Software Co. physically delivers the product. However, due
to the extensive customization efforts, the control over the software transfers
continuously. Finally, the control over the ongoing support services also transfers
continuously. Under the proposed model, revenue for the hardware is recognized upon
delivery, while revenue for the other performance obligations is recognized continuously
over the performance period. Under current GAAP, the entire arrangement would be
accounted for under the percentage-of-completion approach, and revenue would be
recognized over the performance period in proportion to the costs incurred. This could
result in a materially different pattern of revenue recognition compared to the proposed
model, particularly for the hardware.
Chapter 6: Satisfaction of performance obligations
60 Financial reporting developments The road to convergence: the revenue recognition proposal
6.2 Recognizing revenue when a right of return exists
As discussed in Section 3.6, the ED concludes that a right of return does not represent a
separate performance obligation. Instead, the existence of a right of return affects the
amount of revenue an entity can recognize for transferred performance obligations, as the
entity must determine whether the customer will return the transferred product.
Similar to the accounting for variable consideration discussed in Section 4.1, if returns are
reasonably estimable, the entity estimates the transaction price based on the probability-
weighted amount of the consideration the entity expects to retain through the end of the
return period. The amount of expected returns is recognized as a refund liability, representing
the entity‘s obligation to return the customer‘s consideration for expected failed sales. If the
entity is unable to estimate the probability of returns, revenue is not recognized until that
probability can be reasonably estimated, which may be at the end of the return period.
An entity must remeasure refund liabilities, once established, at each financial reporting date
for changes in assumptions regarding expected returns. Any adjustments made to the
estimate would result in a corresponding adjustment to amounts allocated to the satisfied
performance obligations (e.g., if the entity expects the number of returns to be higher than
originally estimated, it would have to decrease the amount of revenue recognized and
increase the refund liability).
Finally, when customers exercise their rights of return, the entity may receive the returned
product in saleable or reparable condition. Under the proposed guidance, when the initial sale
is recognized as revenue, the entity also recognizes an asset separate from inventory (and
adjusts cost of sales) for its right to recover the goods returned by the customer. The asset is
initially measured at the former carrying amount of the inventory less any expected costs to
recover the goods. Along with remeasuring the refund liability at each financial reporting
date, the entity would update the measurement of the asset recorded for any revisions to its
expected level of returns. Additionally, the asset recorded is subject to impairment.
Example 27 — sale of a product with a right of return
Pharma sells 1,000 units of Product A to Distributor for $100 each. Payment is due to
Pharma 30 days after the units are transferred to Distributor. Pharma allows its customers
to return Product A six months prior to or six months after the designated expiration date
for a full refund. The cost of each unit is $50.
Pharma estimates, based on a probability-weighted average calculation, that 4% of sales of
Product A will be returned by the customer for a full refund. Therefore, 4% of the sale to
Distributor would be recognized as a refund liability rather than revenue (4% x (1,000 units
x $100) = $4,000).
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 61
Upon the transfer of control of Product A, Pharma would record the following entries:
Dr. Accounts receivable 100,000
Cr. Revenue 96,000
Cr. Refund liability 4,000
To record revenue and the refund liability
Dr. Cost of sales 48,000
Dr. Return asset 2,000
Cr. Inventory 50,000
To record the cost of sales, relief of inventory and the return right
Subsequent to the initial transfer of Product A, Pharma determines that it now expects
Distributor to return 5% of the units of Product A rather than the 4% originally estimated.
Because changes in estimated returns are recognized as an adjustment to revenue and
cost of sales, with corresponding recognition of a refund liability and return asset, the
following entries would be recorded:
Dr. Revenue 1,000 [(5% - 4%) x (1,000 units x $100)]
Cr. Refund liability 1,000
To adjust refund liability for change in estimated returns
Dr. Return asset 500 [(5% - 4%) x (1,000 units x $50 cost)]
Cr. Cost of sales 500
To adjust return asset for change in estimated returns
However, to the extent Pharma determines that any drug returns are likely to have
diminished value, it also would recognize an impairment on the recorded return asset.
How we see it
While the accounting for rights of return should not be a significant shift from current
practice, there are some notable differences. Current US GAAP is similar to the proposed
guidance with the main difference being the accounting for the right of return asset. Under
current US GAAP, the carrying value associated with any product expected to be returned
typically remains in inventory, whereas the proposed guidance requires the asset to be
recorded separate from inventory to provide greater transparency. Additionally, the
proposed model is clear that the carrying value of the return asset (i.e., product expected
to be returned) is subject to impairment testing on its own, separate from other inventory
on hand. Under current US GAAP, as expected returns remain within inventory, they are
not subject to separate impairment testing.
Chapter 6: Satisfaction of performance obligations
62 Financial reporting developments The road to convergence: the revenue recognition proposal
6.3 Repurchase agreements
Certain agreements executed by entities include repurchase provisions, either as a
component of a sales contract or as a separate contract that relates to the same or similar
goods in the original agreement. The ED addresses whether a customer has obtained control
of an asset in arrangements containing such repurchase provisions. Paragraph 48 of the ED
identifies three main forms of these provisions:
1. A customer‘s unconditional right to require the selling entity to repurchase the asset
(essentially a written put option)
2. An entity‘s unconditional obligation to repurchase the asset in the original contract
(essentially a forward contract)
3. An entity‘s unconditional right to repurchase the asset in the original contract (essentially
a purchased call option)
6.3.1 Written put option held by the customer
The proposed model indicates that if the customer has the ability to require the entity to
repurchase the asset, the customer has obtained control of the asset (i.e., the customer has
the ability to direct the use of the asset) and a sale should be recorded. These arrangements
should be treated essentially the same as a sale with the right of return (discussed in Sections
3.6 and 6.2). Therefore, upon recognizing the sale, the entity also would recognize a liability
for the expected returns, and an asset for product expected to be returned. The ED
acknowledges that there may be situations in which the entity is certain that the customer will
exercise its option to repurchase the asset (e.g., it would be economically disadvantageous to
the customer to not exercise the put option). In such situations, the selling entity would
record a repurchase liability for substantially the full amount of the consideration received
from the customer, adjusted for the time value of money, essentially assuming that all the
products will be returned.
6.3.2 Forward or call option held by the entity
Conversely, if the entity has an unconditional obligation or right to repurchase the asset, the
customer has not obtained control of the asset because it is constrained in its ability to direct
the use of the asset. Therefore, the transaction likely represents a lease or a financing
transaction rather than a sale. The proposed guidance indicates that if the entity is obligated
or has the right to repurchase the asset at a price less than the original sales price, the entity
accounts for the transaction as a lease. If the entity is obligated or has the right to
repurchase the asset at a price equal to or greater than the original sales price, the
arrangement is accounted for as a financing. In the case of a financing arrangement, the
selling entity continues to recognize the asset and records a financial liability for the
consideration received from the customer. The difference between the consideration
received from and the consideration paid to the customer upon repurchase represents the
interest and holding costs, as applicable, that are recognized over the term of the financing.
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 63
Because the proposed model does not consider the likelihood of exercise of a call option held
by the entity in determining the accounting treatment, we believe the potential exists for
counterintuitive accounting results. For example, in certain transactions, an entity may have
an unconditional right to repurchase an asset at an amount greater than the original sales
price. The proposed model will require the entity to account for all such transactions as a
financing, even in situations in which it is highly unlikely the entity will exercise the call option.
Example 29 — vendor obligation to repurchase a good at a price greater than the original
sales price (i.e., forward)
Can manufacturer enters into an agreement to sell a customer aluminum ingots. As part of
the agreement, Can manufacturer also agrees to repurchase the ingots in 60 days at the
original sales price plus 2%. As Can manufacturer has an unconditional obligation to
repurchase the ingots at an amount greater than the original sales price, this transaction is
treated as a financing under the proposed model. If the selling price of the ingots was
$200,000, Can manufacturer would records the following entry when it receives the
consideration from the customer:
Dr. Cash 200,000
Cr. Financial liability 200,000
Further, since the entity has to pay $204,000 ($200,000 x1.02) to repurchase the ingots,
the entity would recognize the $4,000 differential as interest and holding costs over the
60-day period.
Example 30 — vendor obligation to repurchase a good at a price less than the original
sales price (i.e., forward)
A manufacturer of lift equipment enters into an agreement to sell six scissor lifts to a
customer. As part of that agreement, the manufacturer agrees to repurchase the
equipment from the customer in three years at 70% of the original purchase price. Since
the entity has an unconditional obligation to repurchase the assets at a price less than the
original purchase price, the proposed model requires this transaction be accounted for as a
lease. Under the current lease model (ASC 840), assuming the transaction is accounted for
as an operating lease, the initial payment would be recognized as a liability and lease
revenue (the difference between the initial purchase price and the repurchase price) would
be recognized ratably over the three-year lease period. Additionally, the asset remains on
the lessor‘s statement of financial position and is depreciated over its estimated useful life.
Chapter 6: Satisfaction of performance obligations
64 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
The proposed guidance does not differ significantly from the existing treatment of
repurchase agreements under ASC 470-4010 for most transactions; however, entities that
retain an option to repurchase a good from the buyer as a part of sales contracts may see a
change in practice. One of the criterion under ASC 470-40 that results in accounting for a
transaction as a financing arrangement (not a sale) is that a seller‘s option to repurchase a
product contains a significant incentive or economic compulsion for the seller to exercise
the option. For example, an arrangement that includes a significant penalty if the seller
does not exercise the option may fit this criterion would meet this condition. This model
differs from the proposed guidance, which provides that any seller option to repurchase
the product indicates that the buyer does not have control of the product because it is
constrained in its ability to direct its use. Accordingly, while not all seller options to
repurchase results in accounting for the transactions as a financing under current US
GAAP, such options would result in accounting for all such transactions as financing under
the proposed model.
6.4 Licensing and rights to use
Granting licenses and rights to use are common in the software, media and entertainment,
life sciences and many other industries. A license granted to a customer represents the
customer‘s right to use the intellectual property (IP) developed or owned by the entity for its
intended use. Paragraph IG31 of the ED provides the following examples of intellectual
property:
► Software and technology
► Motion pictures, music and other forms of media and entertainment
► Franchises
► Patents, trademarks and copyrights
► Other intangible assets
The proposed guidance for licenses and other rights of use (collectively, licenses) requires an
analysis of the customer‘s rights to determine the appropriate accounting treatment. The ED
provides that if a customer (licensee) obtains control of substantially all of the rights
associated with the entity‘s (licensor‘s) intellectual property, the arrangement is considered a
sale as opposed to a right to use the IP. For example, under the proposed guidance if a
licensor grants the licensee the exclusive right to use the IP for substantially all of the IP‘s
economic life, the licensee is deemed to have obtained control of substantially all of the rights
associated with the IP.
10 ASC 470-40, Product Financing Arrangements
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 65
When a licensee does not obtain control of substantially all of the rights associated with the IP
(e.g., the right to use the IP is for a defined period of time that is less than the economic life
of the IP), the transaction can be treated in one of two ways.
If the licensor grants rights that are not exclusive, the right to use is generally a single
performance obligation that is satisfied when the customer is able to use those rights. Rights
of use are considered to be non-exclusive if the licensor is able to grant similar rights to other
parties using substantially equal terms. For example, this occurs frequently in the software
industry in which software developers sell software licenses to a number of customers with
substantially the same terms.
Conversely, if the licensor has granted exclusive rights of use to the licensee, the licensor
would be unable to grant a similar right to any other party at the same time, indicating that
the licensor‘s ability to control the IP is constrained during the license period. The Boards
concluded that this constraint suggests that the licensor has a performance obligation that
will not be fully satisfied until the end of the license period. The licensor‘s performance
obligation, therefore, would be satisfied continuously over the course of the licensing period.
Immediate recognition of revenue may also be precluded upon granting rights of use to more
than one party if some parties obtain rights that differ substantially from the rights obtained
by others. This is an indication that each party was granted exclusive rights under their
respective arrangements and for which revenue would be recognized over the license period.
Paragraph IG37 of the ED describes example bases of exclusivity.
Excerpt from the ED
IG37. An entity might grant rights to more than one customer to use the same intellectual
property. However, the rights of one customer might substantially differ from the
rights granted to another customer. Hence, those rights would be exclusive. An entity
might grant exclusive rights on the basis of the following:
(a) time — for example, a motion picture studio granting one customer the exclusive
right to air a television series during one time period and granting another
customer the exclusive right to air the same series during another time period;
(b) geography — for example, a franchisor granting one customer the exclusive right to
a franchise in a particular region and granting another customer the exclusive right
to the franchise in a different region;
(c) distribution channel or medium — for example, a record label granting one customer
the exclusive right to distribute a soundtrack on compact disc and granting another
customer the exclusive right to distribute the soundtrack via the internet.
Chapter 6: Satisfaction of performance obligations
66 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
Current US GAAP for rights of use differs by industry, typically addressing only specific
types of transactions and leaving many transactions and entities with no specific guidance.
Entities without specific guidance generally analogize to the industry-specific guidance that
most closely resembles the transaction type. The analogy to specific accounting literature
is fairly clear for some types of intellectual property. For example, intellectual property
that is primarily composed of content, such as a book or magazine, arguably is similar to a
film, and a publisher might conclude that an analogy to the guidance of ASC 92611 may be
most appropriate. However, in many cases an analogy to specific accounting literature is
not clear, which leads to differences in practice. The proposed guidance solves this issue by
proposing a single model applicable to all licensing transactions and provides guidance for
those transactions for which specific guidance historically has not existed.
However, the proposed model in the ED presents a significant change in practice for the
recognition of revenue for transfers of intellectual property rights that contain exclusivity
clauses. For example, those entities in the media and entertainment field that grant
exclusive licenses to intellectual property for a defined period of time or in a specific
geography will likely be required to account for the revenue earned over the term of the
license period. Currently, those entities are able to account for such revenue upon delivery
(assuming all other revenue recognition criteria are met).
6.5 Bill-and-hold arrangements
Certain sales transactions may result in the selling entity fulfilling its obligations under the
sales contract and billing the customer for the work performed but not shipping the goods until
a later date. These transactions are referred to as ―bill-and-hold‖ transactions. Bill-and-hold
transactions are usually designed as such at the request of the purchaser for a number of
reasons, including a lack of storage capacity or delays in its ability to use the goods.
Under the proposed model, the selling entity must evaluate whether the customer has obtained
control of the goods in order to determine the performance obligation has been satisfied and to
recognize the related revenue. As the customer has not taken possession of the goods in a bill-
and-hold transaction, the proposed guidance includes the following criteria that must be met
for a customer to have obtained control of a product in a bill-and-hold arrangement:
► The customer must have requested the contract to be on a bill-and-hold basis
► The product must be identified separately as the customer‘s
► The product currently must be ready for delivery at the location and time specified, or to
be specified, by the customer
► The entity cannot use the product or sell it to another customer
11 ASC 926, Entertainment — Films
Chapter 6: Satisfaction of performance obligations
Financial reporting developments The road to convergence: the revenue recognition proposal 67
If the above conditions are met, the selling entity is no longer able to direct the use of the
goods, but instead acts as a custodian for the customer and the performance obligation has
been satisfied. In that case, however, the selling entity must consider whether custodial
services are a material separate performance obligation for which a portion of the
transaction price would be allocated and recognized as revenue during the custodial period.
How we see it
The criteria for determining whether a bill-and-hold transaction qualifies for revenue
recognition under the proposed guidance are similar to, but somewhat less detailed than,
the criteria established in SAB Topic 13 that govern accounting for bill-and-hold
transactions today. Because the general principles within the proposed model are similar to
current guidance, we expect that most bill and hold transactions that would qualify for
revenue recognition under current US GAAP will also qualify for revenue recognition under
the proposed model.
6.6 Customer acceptance
Certain sales contracts include customer acceptance clauses specifying that the customer
must approve (accept) the goods before the customer becomes obligated to pay. These
clauses may be straightforward and simply provide a customer the ability to accept or reject
the delivered goods based on objective criteria specified in the contract (e.g., the goods
function at a specified speed) or may be more subjective in nature. The determination of
whether the customer has obtained control of the good or service must consider any
customer acceptance clauses in the agreement because without satisfying the customer
acceptance clauses in the contract, the entity may not be entitled to consideration, or may be
required to take remedial action before it has satisfied its performance obligations.
The proposed model states that if an entity can objectively determine that a good or service
has been transferred to the customer in accordance with the agreed specifications in the
contract, then customer acceptance is a formality that would not affect an entity‘s
determination of when the customer has obtained control of the good or service.
Contractually specified height, weight or other measurements are examples of customer
acceptance requirements that would be objectively determinable. Conversely, if the entity is
unable to objectively determine that the good or service meets the contractual specifications,
then it would be unable to conclude that the customer has obtained control before the
customer‘s acceptance of the goods. A clause that allows the customers to visually inspect,
test and apply judgment in determining whether a particular good is suitable may represent a
customer acceptance criterion that is not objectively determinable.
Chapter 6: Satisfaction of performance obligations
68 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
The proposed guidance for accounting for customer acceptance provisions does not vary
significantly from the relevant guidance provided in SAB Topic 13 applicable today. Under
the proposed model, acceptance clauses that create uncertainty about the customer‘s
acceptance of delivered products should still be presumed to be substantive elements of an
arrangement that generally will preclude revenue recognition until formal customer sign-
off is obtained, or the acceptance provisions lapse. Determining when a vendor may
recognize revenue for an arrangement including customer-specified acceptance criteria
prior to obtaining formal customer signoff requires the use of professional judgment and
depends on the weight of the evidence in the particular circumstances.
Chapter 7: Other measurement and recognition topics
Financial reporting developments The road to convergence: the revenue recognition proposal 69
7.1 Onerous performance obligations
The proposed model requires that an entity recognize a liability and a corresponding expense
when any performance obligation becomes onerous. Under the proposed model, a
performance obligation is deemed onerous when the present value of the probability-
weighted expected direct costs of fulfilling the performance obligation are greater than the
amount of the transaction price allocated to the performance obligation. (While the proposed
model is silent on the appropriate discount rate to use in performing this calculation, we
believe using an entity-specific discount rate is appropriate since the measure is only the
entity‘s cash outflows and unrelated to the counterparty.) In making this assessment, the
proposed model is clear that the measurement should consider only direct costs incurred in
connection with the individual performance obligation. Consistent with the guidance on
contract costs (see Section 7.2), direct costs would include direct labor, direct materials,
allocated costs that relate directly to the performance obligation‘s activities
(e.g., depreciation), costs explicitly chargeable to the customer based on the contract terms
and other costs incurred only because the entity entered into the contact with the customer.
The proposed guidance requires the assessment of potential onerous performance
obligations be performed for each performance obligation within a contract, rather than for
the contract as a whole. This could result in liabilities recorded for onerous performance
obligations when the overall contract is expected to remain profitable. The Boards
acknowledge this issue and concluded it is consistent with the proposed model‘s objective to
reveal different margins on different parts of the contract. Those different margins are
revealed by identifying separate performance obligations and consequently the same unit of
account should apply to test whether those separate performance obligations are onerous.
The proposed guidance also explains that, before recognizing a liability for an onerous
performance obligation, the entity is required to determine whether any impairment exists
for the assets related to the contracts (e.g., inventory, engineering) and recognize any
impairment loss that has occurred.
Once the entity has recorded a liability and corresponding expense for an onerous
performance obligation, the proposed guidance requires that the measurement of the
obligation be updated at each financial reporting date to include changes in assumptions or
new information. Changes in the measurement of the liability are recorded as an increase or
decrease in expense in that period (note that the liability could never become negative; that
is, an asset). Upon satisfaction of the onerous performance obligation, the entity would
recognize the corresponding income as a reduction in expense.
Chapter 7: Other measurement and recognition topics
Chapter 7: Other measurement and recognition topics
70 Financial reporting developments The road to convergence: the revenue recognition proposal
How we see it
In principle, the notion of recognizing a liability and corresponding expense for onerous
performance obligations is not a significant change in practice for entities that follow the
construction-type and production-type contracting guidance in ASC 605-35. That guidance
requires the recognition of the entire anticipated loss as soon as the loss becomes
apparent (generally, when estimates of the total contract costs and contract revenue
indicate a loss). However, this proposed guidance likely represents a significant change for
most other transactions. Under current US GAAP, while there is diversity in practice, many
companies do not recognize losses on executory contracts unless there is specific guidance
that requires such losses to be recognized (such as the guidance in ASC 605-35).
The measurement of the amount of loss to be recognized under the proposed model differs
from current US GAAP. The current measurement of an expected loss generally is done at
the contract level, not the performance obligation level. Additionally, the proposed model
requires that the measurement consider the present value amount of probability-weighted
costs relating directly to the satisfaction of the performance obligation, while current US
GAAP requires the consideration of the current estimate of total contract costs. As a
result, the requirements to calculate the present value of future expected costs, to
probability-weight those costs, and to include only those costs that relate directly to the
satisfaction of the performance obligation (see below for a further discussion of costs) all
represent changes from current practice.
Further, the approach outlined in the proposed model indicates that the ―direct costs‖ to
be included in the calculation determining whether a performance obligation is onerous
include allocated costs that relate directly to satisfying the performance obligation. Since
the costs to be included in the calculation are not limited to incremental costs, this
approach potentially will result in recognizing liabilities for onerous performance
obligations for obligations that are expected to increase the net income of the entity. The
following example illustrates this effect.
Example 31 — onerous contract increases profitability of entity
A contractor enters into a long-term arrangement to build a new section of highway for a
state. While the contractor frequently performs this type of construction, it is the first time
it has entered into an agreement with the particular state. As a result, the contractor bid
the arrangement at close to break even in an attempt to gain future business with this
government. Due to early cost overruns, the contractor is concerned that the contract
may become onerous, and performs the required assessment. Based on the contractor‘s
calculation, the contractor determines that the present value of the expected direct costs
exceed the transaction consideration by $40,000.
Chapter 7: Other measurement and recognition topics
Financial reporting developments The road to convergence: the revenue recognition proposal 71
As required under the proposed model, in identifying all of the direct costs incurred and
expected to be incurred, the contractor included the depreciation cost associated with the
equipment needed to perform the job, which is expected to total $80,000 during the
construction period. (The construction of a highway requires a significant amount of
equipment, all of which the contractor already possesses as a result of frequently
performing this type of work.)
However, as the contractor already owns this equipment, these costs are fixed costs of the
entity. Said another way, had the contractor not entered into this particular agreement,
the contractor would still be incurring the depreciation costs. As a result, fulfilling this
arrangement will actually improve the net income of the contractor as the contract will
allow the entity to recover at least some of its direct costs. That is, the contractor will incur
a loss of $40,000 as a result of fulfilling the contract compared to a loss of $80,000 if the
contract had not been entered into.
How we see it
The recognition of losses at the performance obligation level could result in ―day one‖ losses
being recorded on a contract. This may occur when an entity includes one or more low-
margin products in a contract with multiple goods and services or when an entity finds a low-
margin or loss contract acceptable based on some other continuing customer relationship.
For example, a printer manufacturer may be willing to accept losses on printer sales when
the manufacturer is assured that continuing printer cartridge sales will be highly profitable.
Example 32 — occurrence of a ―day one‖ loss
Company A is a calendar year-end IT consulting company that advises clients on process
management. Occasionally, Company A‘s clients request that Company A acquire any
necessary hardware on their behalf as a matter of convenience, which Company A then
sells to the clients with very little margin. On 30 November, Company A negotiates a
contract with Company B to provide consulting services and agrees to provide the
recommended hardware, all by 1 February. The contract requires Company A to provide
two consulting services plus hardware for a total transaction price of $360,000. The
allocation of the transaction price is as follows:
Performance Standalone Allocated
Obligation Cost Selling Price Transaction Price Margin
(relative selling price)
Hardware $ 200,000 $ 210,000 $ 180,000 $ (20,000)
Consulting Service 1 70,000 105,000 90,000 20,000
Consulting Service 2 60,000 105,000 90,000 30,000
$ 330,000 $ 420,000 $ 360,000 $ 30,000
Chapter 7: Other measurement and recognition topics
72 Financial reporting developments The road to convergence: the revenue recognition proposal
Although the contract is a profitable contract, the performance obligation related to the
delivery of hardware is in a loss position at inception. Based on the relative standalone
selling price, the portion of the transaction price allocated to the hardware is less than the
cost of the hardware, indicating the performance obligation is onerous. Company A would
record an onerous performance obligation of $20,000 and record a corresponding cost of
sales for the same amount. At 31 December, Company A would remeasure the onerous
performance obligation to account for changes in assumptions or new information (e.g., an
increase in the cost of the hardware). Upon satisfying the performance obligation related to
the delivery of hardware, Company A would record revenue of $180,000, costs of sales of
$180,000 ($20,000 was previously recorded to cost of sales) and relieve the onerous
performance obligation of $20,000. Upon satisfying the performance obligations related to
the two consulting projects, Company A would record revenue of $180,000 ($90,000 each).
How we see it
In addition to the occurrence of ―day one‖ losses in multiple-element arrangements that
are profitable as a whole, the application of the proposed guidance on onerous
performance obligations may lead to ―day one‖ losses in industries with flexible pricing
models. For example, airlines commonly sell tickets on available seats at high margins for
particular classes of travelers (e.g., first-class passengers, walk-up passengers) but also sell
tickets at very low margins or at a loss. These low-margin or loss tickets are intended to
cover a portion of the fixed costs of transporting passengers. The overall profitability on
passenger contracts is supported by the high-margin ticket sales. In applying the proposed
guidance as written, the airline would be required to record a loss on the date of sale
related to any ticket sale that represents an onerous contract, even though the actual flight
is expected to result in incremental profit to the airline.
7.2 Contract costs
In addition to the proposed revenue model, the ED also provides guidance for accounting for
an entity‘s costs incurred in obtaining and fulfilling a contract to provide goods and services
to customers. This guidance is applicable for both contracts obtained and contracts under
negotiation. This differs from the revenue recognition guidance, which is applicable only once
an entity has obtained a contract.
The ED differentiates between costs that give rise to an asset and costs that should be
expensed as incurred. Under the proposed model, costs incurred that do not give rise to an
asset eligible for capitalization in accordance with other authoritative guidance
(e.g., inventory, property, plant and equipment, software) may be capitalized if the costs
meet all of the following criteria:
► The costs relate directly to the contract (or a specific contract under negotiation) — costs
may include direct labor, direct materials, costs that may be directly allocable to the
activities involved in fulfilling the contract, costs that are explicitly chargeable to the
Chapter 7: Other measurement and recognition topics
Financial reporting developments The road to convergence: the revenue recognition proposal 73
customer under the contract and other costs that were incurred only because the entity
entered into the contract (e.g., costs related to the use of subcontractors).
► The costs generate or enhance resources of the entity to be used in satisfying
performance obligations in the future — costs, such as intangible design or engineering
costs, that relate to future performance and will continue to provide benefit
► The costs are expected to be recovered
The proposed model requires that if the costs incurred in fulfilling a contract do not give rise
to an asset under the criteria above, the costs should be expensed as incurred. Costs that
should be expensed as incurred include:
► Costs of obtaining a contract — selling (including commissions), marketing and advertising
costs and costs incurred during the bidding and proposal or negotiations
► Costs that relate to previously satisfied performance obligations — costs incurred directly
related to past performance for which there is no future benefit
► Costs of abnormal amounts of wasted materials, excess labor or other materials used to
fulfill the contract — costs incurred that do not further the satisfaction of the unfulfilled
performance obligation should be expensed as incurred
To the extent the entity is unable to determine whether certain costs relate to past or future
performance, and they are not eligible for capitalization under other US GAAP, those costs
would be expensed as incurred.
How we see it
Current US GAAP provides little guidance on the capitalization of contract costs, including
costs incurred in obtaining a contract. The guidance that does exist is narrow in scope but
is widely used by analogy. For example, many entities currently capitalize items such as
sales commissions by analogizing to the guidance on deferred loan origination costs in
ASC 310, while under the proposed model such costs are required to be expensed as
incurred as they represent a cost of obtaining a contract. The guidance on capitalization of
costs within the proposed model will affect the amounts entities capitalize for the costs
incurred in obtaining a contract and may affect the amounts capitalized for costs incurred
in fulfilling the contract.
For example, under current US GAAP, many entities capitalize the costs of sales
commissions related to service contracts and expense those costs over the related service
period. Those amounts would be expensed under the proposed model. Further, many
telecommunication companies currently limit the amount of capitalized installation costs to
those amounts that are recoverable under the contract, excluding contingent items. Under
the proposed model, these costs could be capitalized to the extent they are recoverable,
without regard to the potential contingent nature of future services and transaction fees.
Chapter 7: Other measurement and recognition topics
74 Financial reporting developments The road to convergence: the revenue recognition proposal
Any contract costs that the entity capitalizes will ultimately be recognized in income
(generally through amortization) as the entity transfers the related goods or services to the
customer. The proposed guidance requires that assets be amortized to income in a
systematic manner consistent with the pattern of the transfer of goods and services to which
the asset relates. It is important to note that this amortization period could extend beyond a
single contract if the capitalized costs relate to goods or services being transferred under
multiple contracts, or the customer is expected to continue to purchase goods or services
from the entity after the stated contract period.
Any asset recorded by the entity will also be subject to ongoing assessment of impairment
consistent with the proposed guidance on onerous performance obligations. Costs giving rise
to an asset must initially be recoverable in order to meet the criteria for capitalization but
must also continue to be recoverable throughout the arrangement. An impairment exists if
the carrying amount of any asset(s) exceeds the transaction price allocated to the remaining
performance obligations less the costs of satisfying those performance obligations (as
described in Section 7.1).
The proposed guidance does not address whether, once an impairment loss has been
recognized on a capitalized asset, that impairment loss can be reversed if the conditions
causing the impairment loss no longer exist. While the reversal of an asset impairment is
generally not allowed under current US GAAP, such reversal is permitted under IFRS.
Since the ED is intended to be a converged standard, it is not clear which framework this
proposed guidance will follow or, potentially, whether reversals of impairments will be an
area of divergence.
How we see it
The proposed guidance will likely represent a change in practice for the recognition of
costs of sales in many transactions that are comprised of multiple units. In particular, when
the cost of producing individual units varies based on changes in the cost of raw materials,
learning curves experienced with initial products or other variable input costs, the
proposed guidance precludes the normalizing of margins by amortizing costs to units
delivered in equal amounts. Instead, if costs are greater in the early phases of an
arrangement, the costs should be recognized accordingly, resulting in lower profit margins
during the early phases of the arrangement.
7.3 Sale of nonfinancial assets
The ED provides that the proposed guidance would also be applicable to the sale of certain
nonfinancial assets that are not an output of the entity‘s ordinary activities (i.e., not
revenue). This would include the sale of intangible assets and the sale of property, plant and
equipment (including real estate). As a result, the proposed model would provide guidance on
the measurement and recognition of any gain associated with the sale of such assets.
Chapter 7: Other measurement and recognition topics
Financial reporting developments The road to convergence: the revenue recognition proposal 75
While the ED indicates this guidance will be applicable to those transactions, it does not
provide the proposed language for the new guidance (the ED indicates the current guidance
will be completely superseded). Rather, the ED indicates that the applicable guidance will be
issued at some point during the comment period. However, based on the FASB staff
discussion papers on this issue, we believe that the proposed model will require the entity to
derecognize the asset when the buyer obtains control of the asset and recognize the gain or
loss from the transaction based on the difference between the transaction price and the
carrying amount of the asset. Consistent with the discussion above, the determination of
transaction price would take into consideration a number of factors, and would be limited to
the amounts that can be reasonably estimated.
How we see it
The guidance in the proposed model differs significantly from the stringent requirements that
currently exist for sales of real estate. ASC 360-20 includes specific criteria that must be met
to recognize a sale of real estate as well as a number of additional requirements that must be
met in order to recognize profit on a sale of real estate. For example, under ASC 360-20,
profit recognition on the sale of real estate is not appropriate if the seller finances the
transaction and the buyer‘s initial investment (i.e., down payment) ―does not demonstrate a
commitment to pay for the property.‖ ASC 360-20 provides guidelines for minimum down
payments as well as specific bright line down payment requirements for various types of
property. Under the proposed model, a gain may be recognized for a transaction that does
not meet the requirements of ASC 360-20, provided that the expected transaction
consideration is reasonably estimable and exceeds the carrying amount of the real estate
sold. This will represent a significant change in the accounting for sales of real estate.
Chapter 8: Presentation and disclosure
76 Financial reporting developments The road to convergence: the revenue recognition proposal
8.1 Presentation — Contract assets and contract liabilities
The proposed model is based on the notion that when a party to a contract performs, a
contract asset or contract liability is generated. For example, when an entity performs under
a contract by satisfying a performance obligation (i.e., by delivering the promised good or
service), the entity has earned a right to consideration from the customer and, therefore, has
a contract asset. Conversely, when the customer performs first by, for example, prepaying its
promised consideration, the entity has a contract liability.
The proposed guidance requires that the entity present the contract in the statement of
financial position as a contract asset or contract liability when either party to the contract has
performed. In many cases, a contract asset represents an unconditional right to receive the
consideration. This is the case when there are no further performance obligations required to
be satisfied before the entity has the right to collect the customer‘s consideration. The
Boards concluded that an unconditional right to receive the customer‘s consideration
represents a receivable from the customer that is to be classified separately from contract
assets. Contract assets will exist when an entity has satisfied a performance obligation but
does not yet have an unconditional right to consideration, for example, because the entity
first must satisfy another performance obligation in the contract before it is entitled to
invoice the customer.
In addition to the contract asset or liability that is established when either party to the
contract performs, an entity could also have recorded other assets (e.g., costs incurred that
meet the criteria for capitalization) or liabilities (e.g., onerous performance obligations). The
proposed guidance requires that any such assets and liabilities be presented separately from
contract assets and contract liabilities in the statement of financial position (assuming they
are material).
How we see it
The recognition of contract assets and contract liabilities related to a revenue-generating
contract is a new concept for US GAAP entities. Currently, the recognition of similar
assets and liabilities related to contracts (other than contingencies) occurs only in
business combinations.
8.2 Disclosure
8.2.1 Disaggregation of revenue
The disclosure requirements specific to contracts with customers begin with the disclosure of
revenue disaggregated into categories to illustrate how the amount, timing and uncertainty
of revenue and cash flows are affected by economic factors. The proposed guidance suggests
categories such as (a) the type of good or service, (b) the geography in which the goods or
services are sold, (c) the market or type of buyer, such as governmental versus private sector
and (d) the type of contract (e.g., fixed price, time-and-materials).
Chapter 8: Presentation and disclosure
Chapter 8: Presentation and disclosure
Financial reporting developments The road to convergence: the revenue recognition proposal 77
The following is an example disaggregated revenue table that represents the disclosure
requirement.
Summary of
disaggregated
revenue data
Product A Product B Total
2010 2009 2008 2010 2009 2008 2010 2009 2008
Segment 1 $X $X $X $X $X $X $X $X $X
Segment 2 X X X X X X X X X
Segment 3 X X X X X X X X X
Segment 4 X X X X X X X X X
Total $X $X $X $X $X $X $X $X $X
How we see it
The notion of providing disaggregated information currently exists within current US
GAAP, for example, ASC 28012 requires public entities to report certain information about
its operating segments. However, the existing guidance generally is limited to public
companies, so the disaggregated reporting requirements will likely be new requirements
for nonpublic companies. Additionally, the proposed model does not provide guidance on
how an entity determines which categories of revenue should be disclosed, unlike the
segment disclosure requirements, which make clear the determination of which operating
segments must be disclosed is based on what information is available to and evaluated
regularly by the chief operating decision-maker. It is unclear how an entity will determine
which categories must be presented to comply with this disclosure requirement.
8.2.2 Reconciliation of contract balances
The proposed model also requires entities to rollforward contract asset and contract liability
balances in the aggregate. The beginning and ending balances of the rollforward must
reconcile to the statement of financial position and include all of the following, at a minimum:
► The amount(s) recognized in the statement of comprehensive income arising from:
► Revenue from performance obligations satisfied during the reporting period
12 ASC 280, Segment Reporting
Chapter 8: Presentation and disclosure
78 Financial reporting developments The road to convergence: the revenue recognition proposal
► Revenue from allocating changes in the transaction price to performance obligations
satisfied in previous reporting periods
► Interest income and expense
► The effect of changes in foreign currency exchange rates
► Cash received
► Amounts transferred to receivables
► Noncash consideration received
► Contracts acquired in business combinations and contracts disposed
The following is an example of the disclosure requirements related to contract balances
assuming the entity has a net contract asset in the aggregate.
Rollforward of aggregate contract assets 20XX 20XX
Beginning balance $ XXX $ XXX
Amounts includes in the Statement of
Comprehensive Income:
Performance obligations (POs) that were
satisfied during the year (revenue) X X
Reallocation of transaction prices to previously-
satisfied POs +/- X +/- X
Interest income (expense) on prepayments and
payments in arrears +/- X +/- X
Effects of changes in foreign currency rates +/- X +/- X
Customer consideration received in advance (X) (X)
Transfers to Accounts Receivable (X) (X)
Noncash consideration received in advance (X) (X)
Acquisitions (disposals) of contract assets +/- X +/- X
Ending balance $ XXX $ XXX
Chapter 8: Presentation and disclosure
Financial reporting developments The road to convergence: the revenue recognition proposal 79
How we see it
While the requirement to provide account rollforwards is new for revenue-related accounts,
these types of disclosures appear to be in line with the Boards‘ ongoing financial statement
presentation project. Based on the information currently available on that project, including
the Staff Draft posted on the FASB‘s and IASB‘s websites in July 2010, the Boards appear
to be moving toward requiring these rollforwards for all significant accounts.
Entities will have to review their current accounting systems to ensure they have the ability
to collect this type of detailed information on account activity. For many companies,
particularly companies with many subsidiaries, multiple reporting currencies, numerous
accounting systems, etc., this may prove to be a difficult data-gathering process.
8.2.3 Performance obligations
The information required to be disclosed for performance obligations under the proposed
guidance is both quantitative and qualitative in nature. First, the entity is required to disclose
the following qualitative items:
► The goods or services the entity has promised to transfer, highlighting any performance
obligations to arrange for another party to transfer goods or services when the entity is
acting as an agent under the contract
► When the entity typically satisfies its performance obligations (e.g., upon shipment, upon
delivery, as services are rendered or upon completion of service)
► The significant payment terms (e.g., whether the consideration amount is variable and
whether the contract has a material financing component)
► Obligations for returns, refunds and other similar obligations
► Types of warranties and related obligations
In addition to the qualitative discussion of performance obligations, the entity is also
required to disclose quantitative information on the expected timing of the satisfaction of
outstanding performance obligations in long-term arrangements. The proposed standard
requires this type of disclosure on any performance obligation with an original expected
duration greater than one year. The disclosure is required to include the amount of
transaction price allocated to performance obligations expected to be satisfied in:
► one year or less
► between one and two years
► between two and three years
► and those expected to be satisfied in more than three years
Chapter 8: Presentation and disclosure
80 Financial reporting developments The road to convergence: the revenue recognition proposal
The following example illustrates this disclosure requirement.
Summary of outstanding performance obligations
with original durations greater than one year
20XX 20XX
Performance obligations expected to be satisfied in
one year or less
$ XXX $ XXX
Performance obligations expected to be satisfied in
more than one year but less than two years
XX XX
Performance obligations expected to be satisfied in
more than two years but less than three years
XX XX
Performance obligations expected to be satisfied in
more than three years
XX XX
Total $ XXX $ XXX
How we see it
The requirement under the proposed model to provide disclosures on the expected timing
of the satisfaction of performance obligations for long-term contracts represents a new
disclosure requirement for entities applying US GAAP. Many entities may not currently
track or collect the data about the expected timing of when performance obligations are
expected to be satisfied that would be necessary to satisfy this disclosure requirement.
8.2.4 Onerous performance obligations
Under the proposed guidance, onerous performance obligations will require additional
disclosures beyond those required for all performance obligations described in Section 8.2.3
above. The following qualitative and quantitative disclosures are required for onerous
performance obligations:
► A description of the nature and amount of the performance obligations for which the
liability has been recognized
► A description of why those performance obligations have become onerous
► An indication of when the entity expects to satisfy the onerous performance obligations
In addition, entities also must disclose a rollforward of any liabilities recorded for onerous
performance obligations. The rollforward must include all of the following components:
► Performance obligations that became onerous during the period
► Performance obligations that ceased to be onerous during the period
Chapter 8: Presentation and disclosure
Financial reporting developments The road to convergence: the revenue recognition proposal 81
► Amount of the liability that was satisfied during the period
► The time value of money
► Changes in the measurement of the liability that occurred during the reporting period
The following example demonstrates the rollforward required under the proposed guidance.
Rollforward of onerous performance obligations 20XX 20XX
Beginning balance $ XXX $ XXX
Performance obligations that became onerous X X
POs that ceased being onerous (X) (X)
Amount of liability satisfied (X) (X)
Time value of money X X
Change in measurement of the liability +/- X +/- X
Ending balance $ XXX $ XXX
8.3 Significant judgments in the application of the new standard
The proposed guidance requires entities to provide disclosures surrounding the significant
judgments made in the application of the proposed revenue recognition model. First, for
transactions in which performance obligations are satisfied continuously (i.e., control is
transferred continuously, which may be the case, for example, for many services and for
certain long-term construction contracts), the entity must disclose both of the following:
► The methods used to recognize revenue (e.g., output methods, input methods, methods
based on the passage of time)
► An explanation of why the method used is a faithful depiction of the transfer of goods or
services
Entities will often exercise significant judgment when estimating the transaction prices of
their contracts, especially when those estimates involve variable consideration or material
amounts of credit. Further, significant judgment may be required when estimating the
standalone selling prices, returns and onerous performance obligations. The proposed
standard requires qualitative information about the methods, inputs and assumptions used
for the following:
► Determining the transaction price in accordance with the proposed model
► Estimating the standalone selling prices of promised goods or services
Chapter 8: Presentation and disclosure
82 Financial reporting developments The road to convergence: the revenue recognition proposal
► Measuring obligations for returns, refunds and other similar obligations
► Measuring the amount of any liability recognized for onerous performance obligations,
including information about the discount rate used in calculating the present value of the
probability-weighted costs expected to be incurred in satisfying the performance
obligation
How we see it
Many of the proposed disclosures pertaining to the significant judgments made in the
application of the proposed model are consistent with the disclosures required in the
recently revised multiple-element arrangements guidance. However, only a limited number
of companies have adopted this revised guidance to date, so for most entities the extent of
these disclosures represent new requirements. While these disclosures likely will not pose
significant issues for an entity with a simple business model, for those entities with multiple
products and business lines, with differing judgments applied to each, the extent of
disclosures required quickly may become cumbersome and more labor intensive.
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