Revenue recognition for Aerospace and Defense companies

New on the Horizon:

Revenue recognition for Aerospace and

Defense companies

March 2012

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ContentsOne model. Two approaches. Five steps. One more chance to comment. 1

1. Are the revised proposals good news for A&D companies? 2

2. Key impacts 4

3. Scope 63.1 In scope 63.2 Partially in scope 6

4. Step-by-step 84.1 Step 1: Identify the contract with the customer 84.2 Step 2: Identify the separate performance

obligations 104.3 Step 3: Determine the transaction price 134.4 Step 4: Allocate the transaction price to the

separate performance obligations 174.5 Step 5: Recognize revenue 204.6 Contract costs 264.7 Onerous performance obligations 28

5. Application issues 305.1 Product warranties 305.2 Customer incentives 31

6. Presentation 33

7. Disclosures 34

8. Effective date and transition 37

About this publication 39

KPMG’s Global Aerospace and Defense practice 41

Contact us 41

New on the Horizon: Revenue recognition for Aerospace and Defense companies | 1

© 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.

One model. Two approaches. Five steps. One more chance to comment.A wide range of accounting changes under both US GAAP and IFRS is expected to impact the Aerospace and Defense (A&D) industry. The IASB’s and the FASB’s joint projects range from an overhaul of revenue recognition, a new model for leasing arrangements, and new standards on fair value measurement and financial instruments, among others. We expect the volume and scope of the projects being undertaken by the Boards to result in companies being tasked with implementation of multiple new accounting standards in the coming years, many of which will have impacts beyond accounting.

This publication focuses on the joint revenue recognition project. We welcome the revised proposals on revenue recognition published by the IASB and FASB in November 2011. It is good news that the Boards listened to much of the feedback on the earlier version of the proposals published in 2010. The revised proposals retain a single model with two ways to recognize revenue: over time or at a point in time. The model continues to require a five-step analysis of contracts, focusing on transfer of control.

All companies, under the proposals, would apply the single model. This means a greater degree of judgment would be required, heightening the challenge of consistent interpretation. A&D companies should therefore consider whether the proposals have sufficient clarity to be successfully applied.

The proposals may ultimately represent business as usual for some A&D companies, but it is likely that some would experience some degree of change. A number of revisions to the revenue proposals reflected in the 2011 ED, including a broader scope for the percentage of completion accounting and new criteria for bundling performance obligations, are likely to come as a relief to A&D companies. However, some proposals may be a challenge to apply in the A&D industry and companies should take a keen interest in further developments on the project.

The A&D industry has one more chance to influence a new standard on revenue. We hope that this publication will assist you in gaining a greater understanding of the revenue project and its potential impact on your business. We encourage you to contact us to further discuss the issues raised within and any additional questions you may have on the upcoming standard. The deadline for comment letters is March 13, 2012.

Marty Phillips Brian Heckler Dr. Gerhard DaunerGlobal and National Aerospace and Accounting Advisory Services Diversified IndustrialsDefense Leader Lead Partner European LeaderKPMG in the US KPMG in the US KPMG in Germany

2 | New on the Horizon: Revenue recognition for Aerospace and Defense companies


1. Are the revised proposals good news for A&D companies?

IASB’s and the FASB’s joint revenue project continues to draw attention of A&D companies, although the views on the developments may vary between IFRS and US GAAP issuers. A&D companies actively participated in the consultation on the revenue model proposed in June 2010 (the 2010 ED) and expressed a number of concerns arguing that the 2010 revenue model did not fit the underlying economics of their long-term contracts. The revised proposals were issued in November 2011 (the 2011 ED) and many A&D companies are now analyzing whether their concerns were adequately addressed.

This publication looks at the potential impact of the revised proposals on A&D companies, discusses whether their previous concerns have been adequately addressed, and highlights application issues relevant to both IFRS and US GAAP issuers.

Good news compared to the 2010 ED

●● Percentage of completion method. A broader range of contracts may qualify for the percentage of completion accounting, including a number of arrangements in the A&D industry.

●● New criteria for bundling performance obligations. Bundling is required if certain criteria are met, and a number of A&D arrangements are likely to meet the revised criteria.

●● Input method for measuring progress. The input method is allowed under the 2011 ED provided that it reflects the performance under the contract.

Remaining challenges

●● Unit of account. The unit of account needs to be considered carefully on a contract-by-contract basis, and there may be changes from current accounting.

●● Contract modifications. The number and nature of modifications (including unapproved or unpriced change orders) may create implementation challenges and may defer the recognition of related revenue.

●● Time value of money. The pattern of payments may not necessarily be intended to include a financing arrangement if governments and budgets are involved. The requirements could be challenging to apply in practice.

●● Onerous performance obligations. Applying the ‘onerous test’ at a performance obligation level may result in recognition of an upfront loss at the beginning of an overall profitable contract.

●● Accounting for costs. The 2011 ED does not include comprehensive guidance on cost accounting.

●● Disclosure. Increased qualitative and quantitative disclosure requirements may require new internal processes and systems for collecting underlying data.

●● Transition. The volume, complexity, and long-term nature of contracts may lead to challenges with retrospective application.



Although the overall developments on the revenue project may come as good news for many A&D companies, there may be some uncertainty as to whether the proposals are sufficiently clear to be interpreted and applied consistently across the industry. Additionally, some fear that the disclosure proposals will require significant investment in order to track and report additional information.

This publication focuses on the challenges facing A&D companies reporting either under US GAAP or IFRS. For a full discussion of the revised proposals, you may want to read our cross-sector publications New on the Horizon: Revenue from contracts with customers; Defining Issues: Boards Release Revised Revenue Recognition Exposure Draft; Issues In-Depth: Boards Revise Joint Revenue Recognition Exposure Draft.

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/New-on-the-Horizon/Documents/NOTH-revenue-from-contracts-a.pdf

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/New-on-the-Horizon/Documents/NOTH-revenue-from-contracts-a.pdf

http://www.kpmginstitutes.com/financial-reporting-network/insights/2011/pdf/di-11-62-boards-release-revised-revenue-recognition-exp.pdf

http://www.kpmginstitutes.com/financial-reporting-network/insights/2012/pdf/iid-12-1-board-revise-joint-revenue-recognition-exposure.pdf

http://www.kpmginstitutes.com/financial-reporting-network/insights/2012/pdf/iid-12-1-board-revise-joint-revenue-recognition-exposure.pdf



2. Key impactsThe new standard is expected to have impacts beyond accounting, tax and reporting, and will impact an entity’s business and financial viewpoint, its systems and processes and its people. Below are the key implementation issues that we envisage A&D companies will wish to consider when evaluating the impact of the proposed revenue recognition model.

Accounting, Tax and Reporting

●● Revenue recognition may be accelerated or deferred. Under the 2011 ED, the timing of revenue recognition may change for some A&D companies as compared to current reporting. Some arrangements, for which revenue is currently recognized at a point in time, may meet the criteria for recognizing revenue over time and in such cases revenue recognition may be accelerated. Conversely, some arrangements that are currently accounted for using the percentage of completion method may not meet the criteria for recognizing revenue over time, and therefore the recognition of revenue may be delayed.

●● Changes to revenue recognition pattern may need to be communicated in advance of adoption. Retrospective application may impact previously reported financial results. Communication may be required to stakeholders in advance of adoption. A&D companies may consider developing additional ‘non-GAAP’ disclosures in the management commentary to bridge historical performance and analysis.

●● Contract modifications may lead to revenue volatility. Contract modifications may require remeasurement of performance obligations for changes to the transaction price and updated assessments of the progress toward completion. These changes may result in cumulative catch-up adjustments to revenue recorded in the current period.

●● Proposal includes changes to reporting and disclosure requirements. The new reporting and disclosure proposals in the 2011 ED may require companies to change existing reporting packages, which will need to be rolled out to all legal entities/locations globally.

●● Dividends and taxation. Changes to revenue recognition may affect the timing of tax payments and the ability to pay dividends in some jurisdictions.

Systems and Processes

●● New accounting systems and processes may be required. Existing accounting systems and processes may need to be reviewed to determine if they have capability to analyze contracts in accordance with the five steps in the proposed revenue model (see Section 4). Areas of specific challenge for A&D companies may be identifying separate performance obligations, applying the contract modification guidance for potentially hundreds of change orders, applying the ‘onerous test’ at a performance obligation level, and calculating a financing element for each contract if payments do not match the performance progress and the lag extends over one year.

●● Evaluate systems capabilities to account for contract modification. New systems and processes may be required to track and evaluate these modifications, and to remeasure the transaction price and progress toward completion. If the modification results in a new contract, then it will need to be recorded separately in the accounting system and accounted for within the model.

●● Constraining variable revenue may require new processes to track and report progress. Under the proposals, variable revenue is constrained to the amount that an entity is reasonably assured to be entitled to. Companies using the inputs method for measuring progress and recognizing revenue will need to track total inputs to ensure that the related revenue does not exceed the ‘ceiling’. This task may require new processes.

●● New disclosure requirements may require changes to existing accounting systems and processes. Preparing the proposed new disclosures could be time-consuming and may require system changes/upgrades to capture the required information. Processes will need to be reconsidered to ensure that management judgment is exercised at key points as financial information is prepared.

●● Retrospective application required. Applying the proposals retrospectively could require the early introduction of new systems and processes, and a period of parallel running for some entities.



Business

●● All contracts will need to be analyzed based on each step in the proposed model. Conclusions reached will need to be appropriately documented to develop sufficient evidence regarding positions reached.

●● New accounting model may impact internal and external reporting metrics. The impact on financial results, the resulting trends and comparability to historical results should be assessed. Communication with external users about the expected timing of changes and volatility in revenue and earnings, and also with the Board of Directors about impacts on internal metrics, should be considered. Updates to internal metrics may be required, including those linked to performance and compensation.

●● Changes to contract terms and business practices. A&D companies should consider whether changes to standard contract terms and business practices are required to achieve or maintain a particular revenue profile. They also should analyze the impact on contracts currently being negotiated and consider the proposed model when structuring and negotiating new contracts.

●● New estimates and judgments required. The proposals introduce new estimates and judgmental thresholds that may affect the amount or timing of revenue recognition.

People and Change

●● Training staff to apply the new revenue model. The new revenue model will require training of accounting and finance staff, as well as sales and contracting staff, on the accounting application of the standard to new and existing contracts. Also, staff may require training on documenting conclusions reached upon implementation of the standard to current contracts.

●● Training staff on new systems, processes and documentation requirements. The application of the new standard, if approved in the form of the 2011 ED, will likely require changes to existing systems and processes, and staff will need to be trained on these changes.

●● Changes to internal reporting metrics will require educating teams on the implications. Changes to internal reporting metrics need to be communicated effectively throughout the organization to ensure that teams understand the changes and implications, especially for changes to metrics linked to compensation.



3. Scope3.1 In scopeED 1, App A, BC30 Revenue is income arising in the course of an entity’s ordinary activities. Income is defined as increases

in economic benefits during the accounting period in the form of enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants, and that arise in the course of an entity’s ordinary activities.

The proposals in the 2011 ED apply only to one category of revenue: revenue from contracts with customers. Other forms of revenue, for example, interest and dividends, will be dealt with under other IFRSs and US GAAP ASC Topics.

KPMG Observations

The new single revenue standard is intended to replace the following guidance:

●● IFRS – IAS 11 Construction Contracts, IAS 18 Revenue, IFRIC 13 Customer Loyalty Programmes, IFRIC 15 Agreements for the Construction of Real Estate, IFRIC 18 Transfers of Assets from Customers and SIC-31 Revenue – Barter transactions Involving Advertising Services.

●● US GAAP – most of the revenue recognition requirements in ASC Topic 605 Revenue Recognition and industry-specific revenue recognition guidance included therein; additionally, the existing requirements for the recognition of a gain or loss on the transfer of some non-financial assets (e.g. real estate sales within the scope of ASC Subtopic 360-20 Property, Plant, and Equipment – Real Estate Sales) would be amended or superseded to be consistent with the proposed recognition and measurement guidance.

It remains to be seen whether A&D companies feel that the new proposals are clear enough to be applied consistently across the industry.

3.2 Partially in scopeED 11, BC44–BC46 A contract could be partially in the scope of the 2011 ED and partially in the scope of other IFRSs, for

example a contract to lease an asset to a customer (within the scope of IAS 17 Leases or ASC Topic 840 Leases) and to deliver maintenance services on the leased asset (within the scope of the 2011 ED). In such a case, the entity considers whether the other IFRS or US GAAP ASC Topic includes specific guidance on the separation and initial measurement of components of contracts, namely:

●● if the other IFRS or US GAAP ASC Topic includes guidance on separation and/or measurement, then the entity first applies that guidance; or

●● if the other IFRS or US GAAP ASC Topic does not include guidance on separation and/or measurement, then the entity applies the guidance in the 2011 ED.



KPMG Observations

One practical consequence of the proposed approach is that if a contract is partially within the scope of the 2011 ED and partially within the scope of another standard, then the measurement of revenue may depend on the requirements of the other standard. For example, a contract may include a lease of an aircraft and other services.

It is difficult to assess the significance of this proposal at present for A&D companies, given that the Boards have an active project on lease accounting. For example, in the period since publication of the 2010 ED, the Boards have taken tentative decisions that could change when and how consideration is allocated between the lease and service elements of a contract, which is of particular interest to commercial aerospace companies.

Another practical consequence is that it may be necessary to apply more than one methodology to allocate consideration within a single contract. For example, it may be necessary first to allocate the consideration between the revenue and non-revenue elements (i.e. the lease element) using the guidance in another standard, and second to allocate the revenue element between the different performance obligations using the guidance in the 2011 ED (see 4.4). This would require A&D companies to exercise judgment and could be complex to apply.



4. Step-by-stepED 4 The 2011 ED describes a five-step model for revenue recognition.

Contract (or combinedcontracts)

Step 1:

Identify thecontract withthe customer

Step 2:

Identify theseparate

performanceobligations inthe contract

Performanceobligation

1

Performanceobligation

2

Step 3:

Determine thetransaction price

Transaction price for thecontract

Step 4:

Allocate thetransaction price to theseparate performance

obligations in thecontract

Transactionprice

allocated toperformance

obligation1

Transactionprice

allocated toperformance

obligation2

Step 5:

Recognize revenuewhen (or as) theentity satisfies a

performanceobligation

Recognizerevenue

Recognizerevenue

These five steps are discussed in 4.1 to 4.5. The 2011 ED also specifies the accounting for some costs, as described in 4.6. Additional guidance on onerous performance obligations is discussed in 4.7.

4.1 Step 1: Identify the contract with the customer

4.1.1 When to apply the model to a contract

ED 13 A contract is an agreement between two or more parties that creates legally enforceable rights and obligations. A contract need not be written but may be oral or implied by the entity’s customary business practices to the extent that they create legally enforceable rights and obligations.

ED 13 An entity considers the practices and processes for establishing contracts with customers to determine if a contract exists. These practices and processes may vary across jurisdictions and industries, and may be different for different classes of customers or goods or services.

ED 14 A contract exists only if:

●● the contract has commercial substance;

●● the parties have approved it and are committed to perform;

●● the entity can identify each party’s rights regarding the goods or services to be transferred; and



●● the entity can identify the payment terms for those goods or services to be transferred.

ED 15, BC35 Conversely, a contract does not exist if both parties to it have the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party. A contract is wholly unperformed when:

●● the entity has not yet transferred goods or services; and

●● the customer is not yet required to pay any consideration.

KPMG Observations

A key challenge for A&D entities will be to identify the circumstances in which a contract is created by customary business practices. The A&D industry is often characterized by long-term customer relationships, established supply chains, and service contracts extending beyond the initial sale.

For example, in the defense industry a company may start working on a project prior to finalizing some of the contract terms, such as quantity and pricing. This may happen in the US under agreements such as Undefinitized Contract Actions (UCAs), Basic Ordering Agreements (BOAs) and Indefinite Delivery/Indefinite Quantity (IDIQ). Unspecified quantity, which may be at a customer’s discretion, or unspecified price, which may be contingent on specific factors, may not necessarily preclude revenue recognition; however, one of the challenges in such circumstances would be to determine at what point in time the arrangement is deemed to be approved by the parties. Companies would need to analyze these practices to determine whether and when they create a contract.

Another challenge for defense companies is to determine whether and when a contract exists if funding for the contract is subject to government budget procedures, for example when the customer is subject to an annual funding regime. In such circumstances, companies may consider relevant experience with this or similar customers in obtaining the necessary fiscal funding from the relevant government authority.

Additionally, customary business practices with ministries of defense and other government ministries may vary between jurisdictions. For example, contract terms with the US Department of Defense may be different from those with the UK Ministry of Defence.

4.1.2 Combining contracts

ED 16, 17 In most cases, an entity applies the guidance to a single contract. However, an entity combines two or more contracts entered into with the same customer (or related parties) and accounts for them as a single contract if one or more of the criteria in the table below are met.



Contract 1 Contract 2

are combined if they are entered into at or near the same time andone or more of the criteria below are met

they are negotiated as a package with a single commercial objective;the amount of consideration paid in one contract depends on the other contract (for example, apayment in one contract is subject to refund if another contract is not fulfilled as promised); andthe goods or services promised in the contracts (or some goods or services promised in the contracts)are a single performance obligation (see 4.2).

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Criteria for when two or more contracts should be combined:

ED 6 An entity may combine a portfolio of contracts with similar characteristics if the entity reasonably expects that the result of doing so would not differ materially from the result of applying the proposals to the individual contracts.

KPMG Observations

IAS 11.8, 9 Both US GAAP and IFRS currently contain explicit guidance on combining and segmenting construction contracts. The 2011 ED’s proposed approach to combining contracts is similar but not identical to that in IAS 11; the combination criteria in IAS 11 require the contracts to be part of a single project with an overall profit margin. The 2011 ED’s proposed approach to combining contracts also differs in certain respects from the current US GAAP approach under ASC Paragraph 605-35-25-8 Revenue Recognition – Construction-Type and Production-Type Contracts. This may result in outcomes under the 2011 ED different from current practice for entities reporting under US GAAP or IFRS.

4.2 Step 2: Identify the separate performance obligations

4.2.1 When and how to separate performance obligations

ED 23 The next step in applying the model is to identify the separate performance obligations in each contract.

ED 24, 25, App A A performance obligation is a promise in a contract to transfer a good or service, and may be stated explicitly in the contract or may be implicit. Activities that an entity must undertake to fulfill a contract but that do not transfer a good or service to the customer are not performance obligations. For example, administration tasks (e.g. contract drafting, internal and regulatory approvals) required to be undertaken to set up a contract do not constitute a performance obligation.

ED 27–30 In order to identify performance obligations that are accounted for separately, the entity considers whether the promised goods and services are ‘distinct’, by applying the criteria outlined below.



Account for separately unless: (1) highly inter-related and significant integration service and(2) bundle is significantly modified or customized for customer

Pattern of transfer ofthe good/servicediffers from othergoods/services

and

Good or service is ‘distinct’

Vendor regularly sellsgood or service separately

Customer can use the goodor service on its own or

with readily availableresources

or

A performance obligation is a promise (implicit or explicit) in a contract with a customer totransfer a good or service to the customer

As a practical expedient, distinct goods and services transferred to the customer at the same time can be accounted for as a single performance obligation.

Illustrative example – Identification of separate performance obligations

Company Z builds a warship, which includes a next-generation guided missile cruiser that will be developed based on the specifications of the customer and will be integrated into the warship.

Under this scenario, Company Z would likely consider the delivery of the warship, including the guided missile cruiser, to be a single, integrated performance obligation. This is because delivering the warship involves significant integration of goods and services by the contractor, including project management, assembly, and testing; and the goods are customized as the upgraded guided missile cruiser needs to be integrated into the warship to be operational.

KPMG Observations

The proposals in the 2011 ED in relation to identifying separate performance obligations may be considered good news for those A&D companies that expressed significant concerns that the 2010 ED could have resulted in the identification of hundreds of separate performance obligations within common A&D contracts. The 2011 ED requires bundling of goods and services into a single performance obligation if they are highly inter-related, the entity provides the significant service of integrating those goods and services, and the whole bundle is significantly modified or customized to fulfill the contract. In addition, the 2011 ED includes a practical expedient, which allows entities to account for distinct goods or services transferred to the customer at the same time as a single performance obligation. Many A&D arrangements are expected to meet the criteria for bundling of goods and services into a single performance obligation.



However, there may be some practical challenges for A&D companies. The current unit of account for revenue recognition purposes may not necessarily be identical to a single performance obligation under the 2011 ED. For example, some defense contractors in the US may negotiate their agreements with the US Department of Defense by ‘contract line item numbers’ (CLINs) and may use CLINs, at present, as the unit of account for revenue recognition purposes. A&D companies will have to carefully analyze their arrangements, as under the 2011 ED some CLINs may not represent a single separate performance obligation.

A&D companies also should consider the range of services included in their contracts and whether those services can be bundled into a single performance obligation, or should be accounted for separately. These services may include design and development, low-rate initial production, product testing, full-rate production, assembly, project management and aftermarket support and maintenance. Each of these services and associated deliverables would need to be evaluated against the guidance on identifying separate performance obligations in order to determine the appropriate unit of account.

4.2.2 Contract modifications

ED 18, 19 A contract modification is an approved change in the scope and/or price of a contract. If the modification changes the scope and price of a contract, then the entity applies the model to the modified contract from the point when the change in scope is agreed and the change in price is expected to be agreed.

ED 20, 21 An entity accounts for a contract modification as:

●● a change to the transaction price, if the modification results only in a change in the transaction price (see 4.4.2); and

●● a separate contract, if it adds promised goods and services that are distinct (see 4.2) at a price that reflects the stand-alone selling price of the goods and services, adjusted appropriately to reflect the circumstances of the particular contract.

ED 22 In other cases, an entity accounts for a contract modification as follows.

Are distinct from thosetransferred on or beforethe modification date.

Allocate considerationpromised by thecustomer not yetrecognized to the

remaining separate POs(account prospectively).

Are not distinct from asingle PO which is

partially complete at themodification date.

Update the transactionprice and measure ofprogress – apply thecumulative catch-up

method.

Are a combination ofthese types of POs.

Allocate considerationpromised by thecustomer not yetrecognized to the

remaining separate POs.*

* For a performance obligation settled over time, update the transaction price and measure ofprogress at the modification date.

If the remaining goods or services:



KPMG Observations

The 2011 ED may change current practice for accounting for modifications in the A&D industry.

At present, A&D companies typically account for modifications to contracts prospectively under IFRS. Under the 2011 ED, some modifications may result in a cumulative catch-up adjustment to previously recognized revenue, unless the modification is deemed effectively to result in a separate contract or the goods or services added by the modification are distinct.

However, as discussed in 4.2.1, in some cases an A&D arrangement may meet the conditions for bundling various goods and services in a single performance obligation and also for recognizing revenue over time. In such circumstances, changes in the scope and in the price of a contract are likely to result in an update of the measure of progress towards completion, and the overall cumulative catch-up adjustment to the previously recognized revenue may not be significant.

For example, Company Z builds a military submarine and accounts for it as a single performance obligation satisfied over time. When Z reaches the 25 percent milestone, the customer changes the requirements for the radar systems, which result in a change in the scope of work and an increase in the transaction price. Z determines that the change to the radar systems does not add a distinct performance obligation, and therefore results in the measure of progress decreasing to 20 percent of completion. The combined impact of the increased transaction price and the decreased measure of progress on the previously recognized revenue (catch-up adjustment) may be not significant, such that the accounting outcome could be similar to current practice.

Another change arising from the 2011 ED relates to the recognition threshold for contract modifications. At present, in order to account for a variation in a contract, it needs to be probable that the variation will be agreed by the customer. Under the 2011 ED, changes in the scope of the contract will have to be approved by the parties to meet the criteria for recognition, although changes in the price only need to be expected to be approved. The higher recognition threshold for changes in scope may be a challenge especially for defense companies. It is not uncommon in the defense industry that some changes can be made to a product prior to finalizing contract formalities, including the formal approval of changes in the specification. In such circumstances, defense companies will need to exercise judgment to determine at which point in time the changes in the scope of the contract are deemed to be approved. The timing of recognition of the related changes in revenue may be delayed.

4.3 Step 3: Determine the transaction priceED 50, BC128 The next step in applying the model is to determine the transaction price for the contract. The transaction

price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.

ED 52 Factors to consider when determining the transaction price include:

●● estimates of any variable consideration (see 4.3.1);

●● the effect of the time value of money if a contract includes a significant financing component (see 4.3.2);

●● the fair value of non-cash consideration; and

●● whether a certain amount of consideration payable to the customer is a discount or a payment for distinctive goods or services.



ED 50, 51 In order to estimate the transaction price, an entity assumes that it will fulfill its obligations under the contract, and that the customer will fulfill its obligations. In particular, an entity does not adjust the transaction price to reflect customer credit risk (collectibility). The 2011 ED’s approach to collectibility is discussed in 4.3.3.

4.3.1 Estimating the transaction price when consideration is variable

ED 53 If the consideration payable by a customer is variable, then the entity estimates the transaction price each reporting period. Consideration may be variable due to discounts, rebates, performance bonuses, incentives, contingencies, penalties, refunds, credits, price concessions, etc.

ED 54, 55 In order to determine the transaction price, an entity estimates either the expected value amount or the most likely amount of consideration it is entitled to, whichever has the better predictive value. It is not a free choice and the method selected should be applied consistently throughout the contract.

ED 56 In developing the estimate of consideration, the entity considers historical, current and forecasted information. The entity updates this estimate at each reporting date based on current information.

Illustrative example – Challenges in a first-time project

Defense Contractor P enters into an incentive-based cost-plus contract with its customer to test and modify next-generation missiles over the next 24 months. This is a first-time project for P using new technology.

The contract is based on a target cost of 10,000 plus a 1,000 margin. In addition, P will receive a bonus based on early or on-time delivery or pay a penalty for delayed delivery.

Timing of missile delivery Bonus/(penalty)

From 12 to 18 months 400

From 18 to 23 months 200

On-time delivery at 24 months 100

Late delivery – after 24 months (200)

This is a first-time project with new technology. There is uncertainty about the time required to complete the contract, and therefore uncertainty about the total amount of consideration to which P is entitled. This uncertainty will not be resolved for a significant period of time.

However, P has experience with other similar projects, which it can use to estimate the variable consideration it will be entitled to under this contract.

Assume that P determines that the most likely outcome of the contract is that it will deliver on time in 24 months. By using the most likely outcome model, P estimates the transaction price to be 11,100 (10,000+1,000+100).



KPMG Observations

A&D contracts often include variable pricing components for which a transaction price will need to be estimated. The forms of variable pricing can vary widely as contractors and customers work to structure contracts that share risk between the parties. As new trends in contracting emerge, contractors may experience increased complexity in estimating transaction prices.

Some A&D companies may welcome the new proposals in the 2011 ED that allow entities to use the most likely approach for estimating variable consideration in some circumstances. However, it should be noted that there is no free choice as to estimation basis, and instead the selection depends on the ability of the method to better predict the amount of consideration. In determining which method to apply to estimate variable consideration under the 2011 ED, A&D companies should consider the following:

●● If there is a large number of homogeneous transactions with multiple possible outcomes, the expected value approach may be more predictive.

●● If there are binary outcomes (e.g. a single performance bonus amount that will be paid only if certain criteria are satisfied), the most likely amount approach may be more appropriate.

The proposed approach to variable consideration may be different from the current practice under US GAAP and IFRS of some A&D companies. The proposals may therefore change the timing and amount of revenue recognition compared to current practice. Additionally, challenges may lay ahead in estimating variable consideration under defense contracts, which increasingly include performance-based bonuses or penalties, and other risk-sharing mechanisms.

4.3.2 Time value of money

ED 58–60, BC143 An entity adjusts the promised amount of consideration to reflect the time value of money if the contract includes a significant implicit or explicit financing component. An entity assesses whether a financing component is significant by considering among other things:

●● the length of time between transfer of and payment for the good or service;

●● whether the total consideration would differ substantially if payment was made in cash promptly in accordance with typical credit terms in the industry and jurisdiction; and

●● the interest rate in the contract as compared to the market rate.

As a practical expedient, an entity is not required to make this assessment if the period between transfer of control of goods or services and payment is expected to be one year or less.

ED 58, BC144, If the financing component is determined to be significant, then the entity adjusts the consideration BC152, BC155, IE8 using a discount rate that reflects the customer’s or vendor’s specific credit risk (i.e. a risk-adjusted rate).

If the cash is received from the customer before the goods or services are transferred, then the vendor’s rate is used. If the goods or services are transferred first, the customer’s rate is used.

ED BC144 The objective of discounting is that the revenue recognized on transferring a good or service is the ‘cash selling price’ for that good or service.



Illustrative example – Adjusting consideration for the time value of money

Company Y manufactures airplanes mainly for private customers. Y enters into a contract with customer Z to deliver an airplane in 18 months for 10,000. A 10 percent payment is due at the contract inception and the final payment of 90 percent is due on delivery to the customer. Y manufactures similar airplanes for various customers, which are largely interchangeable, and does not have any contractual or practical limitations in redirecting a particular plane to another customer. Therefore, Y concludes that it should recognize revenue when the airplane is delivered to the customer.

Y determines that the contract includes a significant financing component and therefore accretes interest expense on the contract liability each period until delivery of the airplane. As a consequence, total revenue on the contract will exceed the contract’s stated amount of 10,000 due to the imputed interest on the 1,000 deposit payment made by the customer.

KPMG Observations

The proposals in the 2011 ED may result in a change in practice for A&D companies. For some A&D contracts, companies may require advance payments for long-term contracts either to protect themselves against credit risk or to cover upfront costs on the purchase of raw materials and components. In addition, contracts that feature progress payments as certain milestones are reached are also common. In both cases, the cash received may not always align directly with work performed or costs incurred. Under the 2011 ED, advance payments and progress payments that are not aligned with work performed would need to be evaluated to determine whether the arrangement contains a significant financing component.

Although the 2011 ED includes a practical expedient allowing entities not to adjust the transaction price for the time value of money if the time lag between the payment and the transfer of the related goods or services is less than one year, the proposals may be challenging to apply, especially when revenue is recognized over time. A&D companies would need to compare their performance each period to any advance or progress payments received. If the timing of performance relative to the receipt of payments indicates that a significant financing component may be present, then interest income or expense would be recognized over the course of the contract.

Another challenging issue is financing from a government contract. Some argue that the pattern of payments under contracts with a government quite often does not reflect an intention to provide financing but rather depends on the budgeting considerations in a particular jurisdiction. For example, in order to avoid losing budgeted funds, some significant advance payments may be made with respect to current and future planned projects at the end of the government spending/budget period. Under the 2011 ED, entities would consider typical credit terms in the industry and jurisdiction when analyzing whether an arrangement includes a significant financing component. The Basis for Conclusions to the 2011 ED notes that in some circumstances a payment in advance or in arrears in accordance with the typical terms of an industry or jurisdiction may have a primary purpose other than financing. This may impact the analysis to be performed by A&D companies.



4.3.3 Collectibility

ED 68, 69, BC163– An entity does not adjust the transaction price for customer credit risk. This is because the transaction BC170 price – and hence revenue – reflects the amount of consideration that the entity expects to be entitled to,

rather than the amount it expects to receive.

Instead, an entity presents losses due to customer credit risk as an additional line in profit or loss adjacent to the revenue line, both initially when the revenue is recognized if losses arise at that point and subsequently if changes in expected collections occur. The new line includes impairment losses on trade receivables that continue to be recognized and measured in accordance with IAS 39 Financial Instruments: Recognition and Measurement/IFRS 9 Financial Instruments or ASC Section 310-10-35 Receivables – Overall – Subsequent Measurement/ASC Topic 450 Contingencies and changes in contract assets that arise when the entity assesses promised consideration to be uncollectible because of customer’s credit risk.

KPMG Observations

Although under the 2011 ED customer credit risk would not affect the measurement of revenue, and therefore would not result in a change in practice in relation to measurement, its effect will be presented in the statement of comprehensive income in a line adjacent to revenue. This presentation will impact gross profit margin and also increase the transparency and prominence with which the effect of customer credit risk is presented.

A&D companies should consider the impact on gross margin if they currently have significant bad debt expense and communicate with stakeholders if necessary.

4.4 Step 4: Allocate the transaction price to the separate performance obligations

ED 70 The next step in applying the model is to allocate the transaction price to the separate performance obligations identified earlier.

4.4.1 Initial allocation

ED 70–73, BC179 At contract inception, the entity allocates the transaction price to the separate performance obligations based on the relative stand-alone selling prices of the underlying goods and services. If stand-alone selling prices are not directly observable, then an entity estimates them, maximizing the use of observable inputs. Suitable estimation techniques include, but are not limited to, the ‘adjusted market assessment approach’, ‘expected cost plus a margin approach’ and, in some circumstances, the ‘residual approach’.



This approach involves an estimation of the price that customers would pay forproduct sold by considering the pricing of similar products in the marketplace andmaking adjustments to reflect the entity’s cost and margin structure.

theAdjustedmarketassessment

Expected costplus a margin

Residual

This approach involves estimating the entity’s projected costs for the good orand then adding an appropriate margin.

service

This approach is used when selling prices for the product are either highly variable oruncertain and observable prices are available for the remaining performanceobligations. In these instances, the selling price may be the total transaction price,less the stand-alone selling prices of the other deliverables (the residual).

ED 70, 74–76 If a bundle of goods and services is sold at a discount to the sum of the stand-alone selling prices of the goods and services, then the entity allocates the discount to all the separate performance obligations unless:

●● each good or service (or each bundle of goods or services) is sold regularly on a stand-alone basis; and

●● the observable stand-alone selling prices indicate that the discount should be applied to one or more specific performance obligations.

If both criteria are met, then the discount would be allocated to the separate performance obligation(s) that the two conditions apply to.

Similarly, if the transaction price includes a contingent amount for a distinct good or service, this is allocated to a specific performance obligation if both:

●● the contingency relates specifically to the satisfaction of a specific performance obligation; and

●● the result of the allocation is consistent with the basic principle that allocated consideration reflects the amount that the entity expects to be entitled to in exchange for satisfying each individual performance obligation.

Illustrative example – Allocating the transaction price to separate performance obligations

Company Y enters into an agreement with a commercial customer for the sale of 20 airplanes for 25,000, which includes aftermarket maintenance services for the life of the airplane. The observable stand-alone selling price per plane is 1,200.

Costs to provide aftermarket services vary by contract; however, Y uses its prior experience to estimate an average cost per airplane of 100. Y does not sell the maintenance services separately, but third-party providers charge a 50 percent mark-up on cost. As a result, Y has estimated a selling price of 150 for aftermarket services for each of the 20 airplanes.



Assume for purposes of this example that Y has concluded that all airplanes will be delivered at the same point in time and that the aftermarket maintenance services likewise are expected to be performed at the same pattern for the airplanes and therefore, using the practical expedient (see 4.2.1), Y identifies two performance obligations: the airplanes and the aftermarket maintenance services. Y allocates the total consideration of 25,000 based on its best estimate of the stand-alone selling prices as follows:

Stand-alone selling prices

Relative proportion of selling price Price allocation

20 airplanes (20 x 1,200) 24,000 89% 22,250

Aftermarket maintenance services ((100 + 100 x 50%) x 20) 3,000 11% 2,750

Total 27,000 100% 25,000

Alternatively, under the 2011 ED, if Y were to determine that the stand-alone selling price for its aftermarket services were highly variable (for example, because competitors’ pricing is widely varied and because Y always sells the aftermarket services as a bundle of goods or services at widely varied levels of discounting), Y might apply the residual approach to establishing a stand-alone selling price for the aftermarket services in this contract. In such case, Y would allocate 24,000 to the airplanes (the observable stand-alone selling price for the 20 airplanes) and 1,000 to the aftermarket services (the remainder of the contract’s total transaction price of 25,000).

Note: The example ignores the time value of money.

KPMG Observations

There is no free choice to use the residual method under the 2011 ED. However, the Boards note that a residual or reverse residual technique could be appropriate if the stand-alone selling price for a good or service is highly variable or uncertain. For example, this might be applicable if an observable price is not available for support services to be delivered under a contract.

Another issue for A&D companies to consider is that allocation based on relative stand-alone selling prices may not always reflect the way in which a contract was negotiated with the customer when variable pricing and incentives are present. For example, pricing may be negotiated to achieve specific margins for specific CLINs or contract deliverables. If this is the case, then allocating variable consideration according to relative stand-alone selling prices may result in margins that do not reflect the stated prices in the contract. This difference between the accounting under the 2011 ED and the stated contract terms could impact the way contracts are evaluated, and impact the timing of revenue recognition compared to how the company negotiated the contract.

4.4.2 Changes in the transaction price

ED 77–80 If the transaction price changes, then the entity allocates changes to the performance obligations using the same allocation method it applied initially. This may result in changes in the amount of revenue recognized for satisfied performance obligations. The allocation is not reconsidered if there is a change in the stand-alone selling prices of the goods or services rather than a change in the transaction price.



KPMG Observations

Changes in the transaction price may be common for A&D companies throughout the life cycle of a long-term contract. Variable consideration, cost-plus contracts, contract modifications, and claims may all result in changes to the transaction price. Other changes may result from the resolution of uncertain events or terms.

In response to significant concerns about the 2010 ED expressed by a number of constituents, including A&D companies, the 2011 ED allows changes in a transaction price related to contingent consideration to be allocated directly to one distinct performance obligation if the contingent payments are explicitly related to one product or service and the estimates of those contingent payments were originally allocated to that performance obligation.

However, A&D companies may face some challenges with contracts that have multiple performance obligations if subsequent changes to the transaction price do not qualify for allocation to specific separate performance obligations. Additionally, adjusting revenue related to completed performance obligations will affect reported revenues in the period in which the change is recognized.

4.5 Step 5: Recognize revenue

4.5.1 The transfer of control principle

ED 31–34 BC 85 An entity recognizes revenue when or as it satisfies performance obligations by transferring control of a good or service to a customer. Control may be transferred either over time or at a point in time. This assessment is made at the performance obligation level.

The customer has the ofthe asset, e.g. to deploy the asset in its activities.

ability to direct the use

and

The customer has thefrom the asset, i.e. the present right to obtainsubstantially all of the potential fromthat asset (either cash inflow or reduction incash outflow) through use, sale, exchange, etc.

ability to receive the benefit

cash flows

Control also includes the ability to other parties fromdirecting the use and receiving the benefit from the asset.

prevent

The customer obtains control of agood or service (i.e. an asset) if



KPMG Observations

The move away from a ’risks and rewards‘ approach to the ‘control’ principle is central to many current standard-setting projects (including those on consolidation, derecognition and lease accounting), and has proved controversial in each case. The Boards have backtracked to an extent in the case of revenue, in that the 2011 ED adds transfer of risks and rewards as an indicator of the transfer of control. However, the Boards state that the core principle has not changed compared to the 2010 ED. In assessing when it is appropriate to recognize revenue under the 2011 ED in the particular facts and circumstances of A&D transactions, companies should therefore focus on the transfer of control concept.

4.5.2 Performance obligations satisfied over time

ED 35 An entity may satisfy a performance obligation over time or at a point in time. If an entity satisfies a performance obligation over time, then it recognizes revenue over time, similar to current percentage of completion accounting.

In order to determine when it satisfies a performance obligation, an entity first considers whether it satisfies the performance obligation over time by considering the following criteria.

Performance creates orenhances an asset thatthe customer controls

Performance does not create an asset with alternative use*to the entity and any one of the below criteria are met.

Customersimultaneously

receives benefits asentity performs

Task would notneed to be

reperformed

Entity has right topayment for

performance andexpects to fulfill contract

Performance obligations satisfied over time

e.g. Construction servicewhen work-in progress

is owned by thecustomer in a construction

industry (BC 90)

e.g. Transactionprocessing service

(BC 96)

e.g. Roadtransportation

service (BC 97)

e.g. Providingconsulting report

a right of paymenton termination

(BC 102)

with

* Alternative use exists if the entity has an ability to direct the asset to another customer

Illustrative example – Performance obligation satisfied over time

Defense contractor X enters into an agreement to build a weapons system to be delivered for a fixed price. The equipment is manufactured at X’s facility. Payments are made on a periodic basis by the customer during construction and the legal title of the equipment passes on delivery.



The payments are non-refundable and reflect milestones completed during the period. The weapons system is customized for the customer’s needs and will be ready for use on delivery. If the contract is terminated, then the customer retains the partially-completed system and must pay for any work completed to date.

In this scenario, it appears that X transfers control over the weapons system to the customer over time because the customer controls the equipment throughout the manufacturing process. Additional evidence that control transfers over time is that (1) the weapons system does not have an alternative use to X, as the contract precludes X from directing it to another customer, and (2) X has the right to payment for work to date throughout the contract.

Based on the limited facts in this example, revenue likely would be recognized over time. (This example illustrates that the criteria to recognize revenue over time are not mutually exclusive; in some cases, a transaction may meet more than one of the criteria.)

KPMG Observations

The proposals in the 2011 ED may come as good news for A&D companies who expressed significant concerns that under the 2010 ED they would not be able to recognize revenue until completion of a project. Under the 2011 ED, a broader range of contracts will qualify for an accounting outcome similar to percentage of completion accounting, including a number of arrangements in the A&D industry.

However, the criteria for revenue recognition over time in the 2011 ED are not identical to the current criteria for percentage of completion accounting under US GAAP and IFRS; therefore, A&D contracts will have to be analyzed carefully in order to determine if they meet the criteria for recognizing revenue over time or at a point in time.

The following characteristics of A&D contracts will typically be relevant to assessing whether a transaction meets the criteria for revenue recognition over time:

●● performance over a long period of time;

●● active customer involvement in the project, including planning and design and the production stage (e.g. monitoring progress, inspecting goods and initiating changes orders);

●● contract milestones requiring customer sign-off for acceptance;

●● customer owns the work in progress and any related intellectual property;

●● contractual or practical limitations over whether the product can be readily directed to another customer (e.g. the contract limits the ability of an entity to sell scrap or resell products if the contract is terminated); and

●● non-refundable progress payments.

Each of the above characteristics may in general terms suggest that the recognition of revenue over time is appropriate, though it will be important to evaluate each arrangement against the specific criteria in the 2011 ED.

ED 38, 39 If the entity concludes that the customer obtains control of the goods or services over time, then it applies the revenue recognition method that best depicts the transfer of control of the goods or services, i.e. when performance occurs.



ED 40–45 The entity applies a suitable method of measuring progress consistently to similar performance obligations. The appropriate methods, which ultimately will depend on the specific facts and circumstances of a contract, include:

●● output methods, i.e. methods based on units produced or delivered, milestones, surveys, etc.; and

●● input methods, i.e. those based on efforts expended to date.

ED 46 A single performance obligation may consist of a good and related services and the good may be transferred to the customer a significant time before the services are provided. When applying an input method for this performance obligation, an entity may need to recognize revenue for the good equal to its cost in order to best depict the performance if both of the following conditions are met:

●● the cost of the good represents a significant portion of the total expected costs; and

●● the entity merely obtains a good without significant involvement in its design and manufacturing.

KPMG Observations

A&D companies concerned that the 2010 ED favored the output method for measuring performance may consider it good news that the 2011 ED appears more balanced in its discussion of input and output methods. However, the input method may be used only if it reflects performance under the contract.

At present, A&D companies often prefer to use an input-based measure of performance, such as ´cost to cost´ or ́ hours to hours´, as they believe that the input method best reflects the economics of their business model. Under the 2011 ED, an A&D company will have to consider if the input method appropriately depicts its performance under the contract. If this is not the case, then the A&D company may have to apply an output method for measuring performance. The output method may result in a different pattern of revenue recognition and an uneven profit margin over the life of a contract.

4.5.3 Performance obligations satisfied at a point in time

ED 37 If a performance obligation is not satisfied over time, then it is satisfied at a point in time, when control of the goods or services passes to the customer. The 2011 ED proposes an indicator approach to determining when the customer has obtained control of a good or service.



The customer haslegal title

The customer has anobligation to pay

The customer hasphysical possession

The customer has significantrisks and rewards

of ownership

The customerhas obtained control of a

good or service

The customer has accepteda good or service

There is no hierarchy amongst the indicators and no single indicator in isolation determines whether the customer has obtained control of the goods or services. For example, physical possession may not coincide with control of the goods in the case of consignment arrangements and bill-and-hold arrangements.

KPMG Observations

The indicators for transfer of control under the 2011 ED are different from current revenue recognition criteria under US GAAP and IFRS. It may be a challenge for A&D companies to determine when control transfers and to apply the indicators on a consistent basis. The 2011 ED is explicit that some indicators may be rebutted, for example physical possession may not coincide with the transfer of control. However, it is not clear whether the indicators give two-way evidence as to the transfer of control.

In addition, there are changes to the indicators compared to the 2010 ED. ‘Transfer of risks and rewards’ and ‘customer’s acceptance of the asset’ have been added to the list of indicators. Conversely, ‘design is customer-specific’ is not included in the list of indicators of transfer of control.

4.5.4 Constraining the amount of revenue to recognize

ED 81, 82 The amount of revenue that an entity recognizes when or as it satisfies a performance obligation generally reflects the amount of the transaction price allocated to that performance obligation. However, if the consideration payable by the customer is variable, then the cumulative amount of revenue that an entity recognizes is constrained to the amount that it is reasonably assured to be entitled to.



An entity determines the amount to which it is reasonably assured of being entitled by considering the following question:

the entity has experience with similar types of performance obligations (or access to otherentities' experience); andthe entity’s experience is predictive of the outcome of the contract?

�

�

Revenue recognized tothe extent of the

transaction price allocated

Constrain the cumulative amount of revenueto the amount that it is reasonably assured

to be entitled to

consideration amount is highly susceptible to external factors;uncertainty about amount not expected to be resolved for a long time;entity’s experience with similar contracts is limited; andcontract has large number of possible consideration amounts.

�

�

Factors that make an entity’s experience less predictive:

�

�

Is the entity reasonably assured that it is entitled to the transaction price allocated toperformance because:

satisfied

Yes No

KPMG Observations

A&D companies may face challenges with contracts containing variable consideration due at the end of a contract, incentive payments, unpriced change orders, and/or consideration related to claims for payment which are in dispute. Significant judgment will be required to assess the total amount of revenue the company is reasonably assured of being entitled to under such contracts.

When revenue is recognized over time, a ‘ceiling’ can be reached if the estimated transaction price included significant variable consideration contingent on performance targets not yet achieved. An entity may have included this variable consideration in the estimated transaction price for the performance obligation, but may not be reasonably assured about the amount if the performance targets are not yet met. A&D companies will need to monitor contracts with variable consideration to ensure that no revenue is recognized over the ceiling.



4.6 Contract costs The 2011 ED includes guidance on how to account for the costs that arise when fulfilling or obtaining a

contract with customers.

If the costs of fulfilling a contract are within the scope of another standard (for example, IAS 2 Inventories under IFRS or ASC Topic 330 Inventory or ASC Subtopic 350-40 Intangibles – Goodwill and Other – Internal-Use Software under US GAAP), then an entity applies that standard. In addition, an entity would recognize an asset for certain costs of:

●● fulfilling a contract – if the costs relate directly to a contract, generate or enhance resources, and are recoverable; and

●● obtaining a contract – if the costs are incremental and recoverable.

4.6.1 Costs of fulfilling a contract

ED 91 An entity first considers whether the costs of fulfilling a contract are in the scope of another IFRS or US GAAP ASC Topic; if this is the case, then the entity applies the guidance in that other standard. However if the costs of fulfilling a contract are not within the scope of other standards, then an entity capitalizes the costs if they:

●● relate directly to a contract (or a specific anticipated contract);

●● generate or enhance resources of the entity that are used to fulfill the performance obligation; and

●● are expected to be recovered.

Otherwise, the entity expenses the costs as incurred.

ED 92, 93 The 2011 ED includes a list of direct costs that are eligible for capitalization if other criteria are met, as well as a list of costs that are not eligible for capitalization and therefore are recognized as expenses when incurred.

Direct labore.g. employee wages

Costs that are explicitly chargeable to thecustomer under the contract

Direct materialse.g. inventory to customer

General and administrative costunless explicitly chargeable underthe contract

Allocation of costs that relate directly to thecontract

e.g. depreciation and amortization expenses

Other costs that were incurred only becausethe entity entered into the contract

e.g. subcontractor costs

Costs that relate to satisfiedperformance obligation

� �

�

�

�

�

�

�

�

�

�

�

��

Direct costs that would be eligible forcapitalization if other criteria are met

Costs to be expensed when incurred

i.e. transfer of control already occurred�

Costs of wasted materials, labor, orother contract costs �



KPMG Observations

In the 2011 ED the Boards have made some changes to the proposals in relation to costs, but have not sought to provide comprehensive guidance on cost accounting. In their redeliberations prior to publishing the 2011 ED, the Boards decided not to address some specific issues relevant to the A&D industry.

Recoverable costs

A&D companies will be able to capitalize some indirect costs (i.e. allocations of costs that relate directly to a contract) under the 2011 ED provided that those costs were not solely of a general or administrative nature and that they could be directly linked to and recovered under a specific contract.

Abnormal costs would not be eligible for capitalization under the 2011 ED, unless they are recoverable under a contract (e.g. some defense contracts are priced based on a cost-plus formula, including abnormal costs).

Research and development costs

Currently, development costs are accounted for differently under US GAAP and IFRS. This issue is not addressed in the cost guidance proposed in the 2011 ED, and the difference remains between the two reporting frameworks.

Deferral of production costs

In many long-term contracts, the costs of production decrease over time as know-how is developed and efficiencies are gained. These production costs (e.g. learning curve costs) impact the variable cost per unit on early units of production. These costs can be significant. Some companies defer certain of these costs and recognize them over the units that benefit from the know-how on an average per unit cost basis.

The Boards have tentatively decided not to address or alter the accounting for costs under long-term production contracts. Although accounting for these production costs affects the profit margin that an entity recognizes upon fulfillment of a performance obligation, the Boards tentatively agreed that these costs relate to accounting for inventory and intangible assets and should not be addressed in the revenue project.

However, the Basis for Conclusions to the 2011 ED notes that if an entity has a single performance obligation that is satisfied over time and it uses a cost-to-cost method to measure the progress, then learning curve costs may result in more revenue being recognized in the early phase of the contract.

4.6.2 Costs of obtaining a contract

ED 94, 97 If an entity expects to recover the incremental costs of obtaining a contract, then it recognizes an asset for these costs unless the contract duration is one year or less, in which case it may elect to expense these costs.



KPMG Observations

The 2011 ED represents a change from the 2010 ED with respect to accounting for costs to obtain a contract. The 2010 ED would have required these costs to be expensed as incurred. The 2011 ED requires capitalization of the incremental costs of obtaining a contract that are expected to be recovered from the customer. Companies would retain the option of not capitalizing such costs when the amortization period for those costs would be less than one year.

4.6.3 Amortization and impairment

ED 98 If an entity recognizes an asset for the costs to obtain and/or fulfill a contract, then the entity amortizes that asset consistent with the pattern of transfer of the related goods or services to the customer. The term ‘related goods or services’ refers not only to goods and services in an existing contract, but also to goods or services to be transferred under a specific anticipated contract (e.g. services to be provided under renewal of an existing contract). The entity also considers the need to impair the asset in accordance with IAS 36 Impairment of Assets or ASC Section 360-10-35 Property, Plant, and Equipment – Overall – Subsequent Measurement.

KPMG Observations

The 2011 ED includes specific guidance on the capitalization and amortization of certain contract costs. The amortization period would be guided by the period of expected economic benefit to the company, in some respects similar to determining the amortization period of acquired intangible assets.

4.7 Onerous performance obligationsED 86, 87 An entity evaluates whether a performance obligation is onerous by considering whether the lowest cost

of settling the performance obligation is higher than the transaction price allocated to that performance obligation. This requirement applies only to performance obligations that are satisfied over time and over a period greater than one year.

Transaction priceallocated toperformance

obligationIf <

Lowest cost ofsettling the

performance obligation

Performanceobligation deemed

onerous andloss is recognized

ED 87 The lowest cost of settling the performance obligation is the lower of:

●● the costs that directly relate to satisfying the performance obligation (see 4.6.1); and

●● the amount that would be paid to exit the performance obligation.



The liability for an onerous performance obligation is measured as follows.

Lowest cost of settling the performance obligation

Liability for onerous performance obligation

Allocated transaction price

ED 88 The liability for the onerous performance obligation is reassessed at each reporting date.

ED 89 If an entity determines that a performance obligation is onerous, then it first considers the need to impair any asset recognized for the costs of obtaining or fulfilling the contract. If the amount of the contract loss exceeds the carrying amount of the related assets, then the entity recognizes a separate liability for the excess.

KPMG Observations

The proposals in the 2011 ED in relation to onerous performance obligations introduce a change to the current practice of accounting for onerous or loss-making contracts under US GAAP and IFRS.

First, the unit of account for the ‘onerous test’ under the 2011 ED is the separate performance obligation, not the contract. Under the 2011 ED, an entity would be required to recognize a loss on a separate performance obligation even if the contract overall is expected to be profitable. However, as noted above, in many cases an A&D arrangement is likely to meet the criteria for bundling of various goods and services into a single performance obligation, and therefore the accounting outcome may not be significantly different from current practice for these arrangements.

Second, the 2011 ED’s guidance on onerous performance obligations applies only to obligations that are satisfied over a period of time that at contract inception is expected to be greater than one year; it does not apply to performance obligations expected to be satisfied over a shorter period or at a point in time.

Third, there may be differences in the measurement of an onerous obligation from current practice. The 2011 ED proposes to measure the liability at the lowest cost of settling the performance obligation. This may differ from the amounts that entities currently consider when assessing total contract costs under US GAAP and IFRS. The 2011 proposals are silent on the question of whether a provision recognized for an onerous performance obligation should be discounted or not.



5. Application issues5.1 Product warranties ED B10–B12, An entity distinguishes between two types of product warranties: the assurance-type warranty that BC284, BC285 covers compliance of the product with agreed-upon specifications, and the service-type warranty that may

provide a service in addition to compliance with agreed-upon specifications. Only the latter is a separate performance obligation.

An entity distinguishes the types of product warranties as follows:

Does the customer have the option to purchase thewarranty separately?

Does the promised warranty, or a part of the promised warranty,the customer with a service in addition to the assurance

that the product complies with agreed-upon specifications?provide

Not a separate performance obligation – the entity accountsfor the warranty in accordance with IAS 37 or ASCTopic 450

Separateperformance

obligation

Yes

Yes

No

No

ED B13 The 2011 ED includes indicators to help determine whether a promised warranty constitutes a separate performance obligation:

●● if the warranty is required by law, then this is an indicator that the warranty is not a separate performance obligation;

●● the longer the warranty period, the more likely the warranty is a separate performance obligation and not only assurance that the product complies with agreed-upon specifications; and

●● tasks that must be performed by an entity so as to provide assurance-type warranty (e.g. shipment of replacement for defective products) are not likely to give rise to a separate performance obligation.

ED B14 If an entity provides a warranty that includes both assurance and service-type features but cannot reasonably account for them separately, then the entity would account for them together as a single separate performance obligation.

ED B15 Legal requirements to pay compensation if products cause harm or damage as well as promises to indemnify a customer for liabilities or damages (e.g. arising from claims of copyright infringement) would not be separate performance obligations; instead they would be accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets under IFRS or ASC Topic 450 Contingencies under US GAAP.



KPMG Observations

The 2011 ED proposes that only service-type warranties or those sold separately result in revenue deferral; assurance-type warranties that do not represent a separate unit of account would result in a cost accrual.

Standard warranties are general practice for commercial A&D contracts, and for certain defense contracts, to cover repair or replacement of defective products or components identified by the customer after the delivery.

Under current guidance, a standard warranty clause would not preclude recognition of revenue at the date of sale. A warranty provision would be recognized based on an estimate of costs to be incurred for repairing or replacing defective products or components.

A&D companies may also enter into long-term maintenance agreements with customers. These long-term maintenance agreements provide services to the customer. These agreements will likely be accounted for as an additional performance obligation to which a portion of the transaction price would be allocated.

The 2011 ED proposes that if an entity cannot reasonably account for a service-type warranty and an assurance-type warranty separately, then it would account for them together as a single separate performance obligation. This ‘reasonably account’ threshold is an unusual articulation and it is not clear how it is intended to be interpreted.

Under current US GAAP accounting, if an extended warranty or maintenance service is separately priced in a contract, then that service element is recognized based on the stated contract price. Under the 2011 ED, the amount allocated to the warranty or service performance obligation would be based on the relative stand-alone selling price. This may result in more or less revenue being allocated to such elements than under current practice, depending on the company’s current pricing practices.

5.2 Customer incentives

5.2.1 The variety of customer incentives

An entity may provide incentives to a customer as part of a sales contract. Customer incentives offered by a seller can have various forms; they include cash incentives, discounts, volume rebates, free or discounted goods or services, customer loyalty programs, loyalty cards and vouchers. Accounting for customer incentives is often a challenging issue.

The diagram below identifies examples of accounting issues related to customer incentives and how they are dealt with in the 2011 ED.



Examples ofcustomerincentives

Accountingissues

Upfrontpayments tocustomers

Volume rebates/early

settlementdiscounts

Free ordiscountedgoods orservices

included ina sales

transaction

Customeroptions for

additional freeor discounted

goods or services

Reduction oftransaction

price orpayment for

distinct goodsor services?

Effect on estimateof transaction

price?

Separateperformanceobligations?

How to allocatetransaction

price?

Does the optionprovide a

material right tothe customer?

KPMG Observations

An A&D company may provide incentives to a customer as part of a sales contract. Customer incentives offered by a seller can have various forms, including cash incentives, discounts, volume rebates, and options to purchase additional future units.

Incentives in commercial contracts are generally intended to encourage customers to buy more products, and often include volume rebates, discounts or cash incentives. These variable customer incentives would be considered when estimating the transaction price if it is concluded that they do not relate to a distinct good or service.

Incentives in defense contracts are often performance-based and are intended to share risks and rewards between the parties. Under this type of contract, a defense contractor would estimate the likelihood of various outcomes when estimating the transaction price using either a most likely or probability-weighted approach.



6. PresentationED 104, 105 An entity presents a contract liability, a contract asset or a receivable (i.e. the net asset or liability arising

from the remaining rights and obligations in a contract) in its statement of financial position when either party to the contract has performed. The entity performs by transferring control of goods or services and the customer performs by paying consideration to the entity.

ED 107 An entity may use alternative captions for the contract asset and contract liability in its statement of financial position. However, an entity should provide sufficient information to allow a contract asset to be distinguished from an unconditional right to receive consideration.

Certain other assets and liabilities that arise during the life of a contract with a customer would be presented separately from the contract asset or liability.

ED 106 ● If an entity has performed before the customer pays consideration, then an unconditional right to consideration is presented as a receivable and accounted for in accordance with the requirements of the financial instruments standards. A right to consideration is unconditional when nothing other than the passage of time is required before the consideration is due.

●● An asset arising from the costs of obtaining a contract is presented separately from the contract asset or liability.

ED 108 ● A liability recognized for an onerous performance obligation is presented separately from any contract asset or contract liability.

KPMG Observations

Under current US GAAP and IFRS, entities applying the percentage of completion method present amounts due from customers for contract work as an asset (if work performed exceeds billings), and amounts due to customers for contract work as a liability (if billings exceed work performed). For other contracts, entities present accrued/deferred income, or payments received in advance/on account, to the extent that payment is received before or after performance.

ED 100, IE16 The 2011 ED states that an entity would present a contract asset or liability only after at least one party to the contract has performed. However, Illustrative Example 16 suggests that an entity may recognize a receivable at inception of a non-cancellable contract before either party to the contract has performed in certain circumstances. Thus, it is unclear what is meant by an unconditional right to consideration and in what circumstances an entity should present a receivable.

Curiously for a due process document on revenue, the presentation section of the 2011 ED is generally silent on the presentation of revenue in the statement of comprehensive income. However, the 2011 ED is clear that certain items are not presented as revenue.

●● If a transaction includes a significant financing component, then the entity presents the effects of financing as interest income or expense.

●● The effects of a customer’s credit risk are presented as a separate line item adjacent to revenue.

●● If a liability for an onerous performance obligation is remeasured, then remeasurement gains and losses are presented separately from revenue.



7. DisclosuresED 109 The 2011 ED requires that an entity make extensive disclosures intended to assist the users of financial

statements to understand the amount, timing and uncertainty of revenue and cash flows arising from contracts with customers, including disclosures about:

●● contracts with customers;

●● the significant judgments and changes in judgments made in applying the proposals to those contracts; and

●● assets recognized from the costs to obtain or fulfill contracts with customers.

ED 113–123 Proposed disclosures about contracts with customers include:

●● one or more disaggregations of revenue for the period, into the primary categories that depict how the amount, timing and uncertainty of revenue and cash flows are affected by economic characteristics (e.g. by type of goods or services, type of contract, geography, and/or market);

●● reconciliations from the opening to the closing aggregate balance of contract assets and contract liabilities, including all amounts recognized during the period in respect of revenue from customers;

●● reconciliations from the opening to the closing balance of the liability for onerous performance obligations; and

●● information about performance obligations including an explanation of when the entity expects to recognize the amount of the transaction price allocated to the remaining performance obligations as revenue if the contract had an original expected duration of more than one year.

ED 124–127 Proposed disclosures about significant judgments include the following.

Judgments in determining the timing ofsatisfaction of performance obligations

Judgments in determining the transactionprice and allocating it to performance

obligations

For performance obligations satisfiedover time, disclose:

the methods used to recognize revenue(output method, input method); andan explanation of why such methodsfaithfully depict the transfer of goodsor services.

Disclose information about the methods,inputs and assumptions used to:

determine the transaction price;estimate stand-alone selling prices;measure obligations for returns, refunds,etc; andmeasure the liability for onerousperformance obligations.

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For performance obligations satisfiedat a point in time, disclose judgments madein relation to transfer of control of goodsor services.



ED 128 Proposed disclosures about assets recognized from costs to obtain or fulfill contracts with customers include:

●● a reconciliation from the opening to the closing balance of the assets, by main category of asset (e.g. pre-contract costs, set-up costs and costs to obtain contracts); and

●● the method used to determine the amortization of those assets for each reporting period.

ED D19 The 2011 ED proposes a consequential amendment IAS 34 Interim Financial Reporting and ASC Topic 270 Interim Reporting under which the following disclosures would be required in interim financial statements:

●● one or more disaggregations of revenue for the period, into the primary categories that depict how the amount, timing and uncertainty of revenue and cash flows are affected by economic characteristics;

●● reconciliations from the opening to the closing aggregate balance of contract assets and contract liabilities;

●● reconciliations from the opening to the closing balance of the liability for onerous performance obligations;

●● for onerous performance obligations, the reasons why the performance obligations became onerous and the period during which the entity expects to satisfy the liability; and

●● a reconciliation from the opening to the closing balance of assets recognized from cost to obtain or fulfill contracts with customers.

KPMG Observations

A&D companies generally expressed the view that the disclosure requirements in the 2010 ED were excessive and that the costs to comply would outweigh the benefits. The 2011 ED substantially retains the disclosure requirements in the 2010 ED and adds disclosures for interim periods. The proposed disclosures are significantly more extensive and detailed than the current requirements in US GAAP and IFRS. For instance, the following disclosure requirements would be new for preparers:

New proposed disclosures Observations

ED 117 Reconciliation of contract balances with revenue It may be challenging for some entities to identify recognized during the period. the aggregate amounts to be included in the

reconciliation when there are complex sales taxes that are included in receivables but excluded from revenue.

ED 118(a), (b), (d), (e) Disclosures about an entity’s performance In our experience, few entities currently disclose obligations, such as when an entity satisfies its such detailed information, and some entities may performance obligations, significant payment not capture this information at the performance terms, obligations for returns/refunds and obligation level.warranties and related obligations.

ED 118(c) Disclosures about any performance obligations In our experience, few entities currently disclose when the entity acts as an agent. such detailed information.



New proposed disclosures Observations

ED 119–121 For contracts expected to be completed after one year from contract inception, the amount of the transaction price allocated to the performance obligations remaining at the end of the reporting period and an explanation of when the entity expects to recognize that amount as revenue.

The 2010 ED proposed fixed time bands for this explanation. That proposal has been replaced in the 2011 ED with a proposal to provide the explanation either on a quantitative basis using appropriate time bands or by using both quantitative and qualitative information.

ED 122, 123 For onerous performance obligations, the reasons why the performance obligations became onerous and the period during which the entity expects to satisfy the liability.

This is more detailed than the current disclosure requirements.

ED D19 Disclosure about contract assets and contract liabilities, performance obligations, onerous performance obligations and assets recognized from cost to obtain or fulfill contracts with customers required in interim financial statements.

This is more detailed than the current disclosure requirements.

The proposed reconciliation from the opening to the closing aggregate balance of contract assets and contract liabilities would be presented on a net basis. In proposing that the reconciliation be presented on a net basis, the Boards are seeking to balance the views of preparers and users of financial statements. Presentation on a net basis would ease the burden on preparers, but would reduce the usefulness of the disclosure to users of financial statements.



8. Effective date and transitionED C1, BC326 The effective date of the new standard will be no earlier than for annual periods beginning on or after

1 January 2015. An entity may adopt the new standard at an earlier date under IFRS, in which case it would disclose that fact. The US GAAP proposal prohibits early adoption and also provides that the effective date for non-public entities would be at least one year delayed from the effective date for public entities.

ED C3 An entity would apply the new standard retrospectively, in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors and ASC Topic 250 Accounting Changes and Error Corrections. However, an entity may take advantage of a number of practical expedients when it first applies the standard.

●● for contracts completed before the date of initial application, an entity need not restate contracts that begin and end within the same reporting period;

●● for contracts with variable consideration that have been completed on or before the date of initial application, an entity is permitted to use the transaction price at the date the contract was completed to determine the revenue in the comparative periods;

●● an entity can elect not to apply the onerous test to performance obligations before the date of initial application except when an onerous contract liability was recognized; and

●● an entity can elect not to disclose the amount of the transaction price allocated to remaining performance obligations and an explanation of when recognition of that revenue will occur.

If an entity elects to apply one or more of the practical expedients, then it applies that expedient consistently to all periods presented and discloses:

●● the expedients that have been applied; and

●● a qualitative assessment of the estimated impact of applying each of the expedients, to the extent reasonably possible.

KPMG Observations

The 2011 ED requires retrospective application but permits a number of practical expedients which may reduce the burden of full retrospective application.

Full retrospective application of the new standard could enhance comparability between entities. However, it may require significant historical analyses to be prepared and could be challenging especially for A&D companies with thousands of contracts that span many years. Many A&D companies may be concerned that:

●● due to the nature of the industry, retrospective application would require recasting thousands of contracts and significant judgment would be required to determine historic assumptions and estimates;

●● due to the judgment required and number of contracts involved, the retrospective application may not result in the same accounting answer as if the standard were in effect since contract inception; and

●● the costs to implement would outweigh the benefits to users.



The IASB and the FASB have different views on early adoption. The IASB proposes that its new standard will permit early adoption but the FASB proposes that its new standard will not. The FASB observed that early adoption would reduce the comparability of financial reporting in the period up to the effective date of the new standard. Conversely, the IASB observed that the new standard would improve accounting for revenue and should resolve some pressing issues in practice arising from existing requirements. Thus, early adoption should not be precluded.

The IASB’s rationale in this regard also is that such provision could allow first-time adopters of IFRS to simply adopt one revenue recognition accounting policy without the need to switch policies in a short timeframe. Further, for existing IFRS issuers, early adoption may allow those companies to avoid tracking their revenue accounting under existing IFRS for current reporting and the proposed standard for retrospective application.



About this publicationThis publication has been produced by the KPMG International Standards Group (part of KPMG IFRG Limited).

ContentOur New on the Horizon publications are prepared upon the release of a new proposed IFRS or proposed amendment(s) to the requirements of existing IFRS. They include a discussion of the key elements of the new proposals and highlight areas that may result in a change of practice.

This edition of New on the Horizon considers the proposals in the IASB ED/2011/6 Revenue from Contracts with Customers and FASB Proposed Accounting Standards Update (Revised), Revenue from Contracts with Customers, which were published jointly by the Boards on November 14, 2011, with additional focus on the potential impact of the proposals on Aerospace and Defense companies.

The text of the publication is referenced to the exposure draft by way of references in the left-hand margin.

Further analysis and interpretation will be needed in order for an entity to consider the potential impact of this exposure draft in light of an entity’s own facts, circumstances and individual transactions. The information contained in this publication is based on initial observations developed by the KPMG International Standards Group, and these observations may change.

Other ways KPMG member firms’ professionals can helpA more detailed discussion of the accounting issues that arise from the application of IFRS can be found in our publication Insights into IFRS.

In addition, we have a range of publications that can assist you further, including:

●● IFRS compared to US GAAP●● Illustrative financial statements ●● IFRS Handbooks, which include extensive interpretative guidance and illustrative examples to elaborate or clarify the practical

application of a standard ●● New on the Horizon publications, which discuss consultation papers●● Newsletters, which highlight recent accounting developments●● IFRS Practice Issue publications, which discuss specific requirements of pronouncements●● First Impressions publications similar to this, which discuss new pronouncements●● Disclosure checklist.

IFRS-related technical information also is available at kpmg.com/ifrs.

We have a range of US GAAP publications that can assist you further, including:●● US GAAP Handbooks which include extensive interpretative guidance and illustrative examples to elaborate or clarify the

practical application of a standard (e.g. Derivatives and Hedging Accounting Handbook, Share-Based Payment, Accounting for Business Combinations)

●● Defining Issues articles, which discuss consultation papers, final standards, certain SEC proposals and releases affecting US financial reporting

●● US GAAP Disclosure checklist.

Technical information on US materials is available at kpmginstitutes.com.

For access to an extensive range of accounting, auditing and financial reporting guidance and literature, visit KPMG’s Accounting Research Online. This web-based subscription service can be a valuable tool for anyone who wants to stay informed in today’s dynamic environment. For a free 15-day trial, go to aro.kpmg.com and register today.

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AcknowledgmentsWe would like to acknowledge the efforts of the principal authors of this publication, which has been developed from our cross-industry publication New on the Horizon: Revenue from contracts with customers. The authors of the cross-industry publication included Celine Hyun, Astrid Montagnier, Brian O’Donovan, Daniel O’Donovan, David Rizik, Andrea Schriber and Anthony Voigt of the KPMG International Standards Group.

The authors of this industry-based publication include Cameron Gwinn, Brian Heckler and Neal McNamara of KPMG in the US and Irina Ipatova of the KPMG International Standards Group.



KPMG’s Global Aerospace and Defense practiceKPMG’s Global Aerospace and Defense practice is a strong network of experienced industry professionals from our member firms who work with clients around the world and help them to make the most of the challenges and opportunities presented by the constantly changing business environment.

Contact usMarty Phillips Global and National Aerospace and Defense LeaderT: +1 678 525 8422E: [email protected]

ASPAC Region

Ken Drover KPMG in Australia T: +61 3 9288 6623E: [email protected]

Martin Sheppard KPMG in Australia T: +61 3 9288 5954E: [email protected]

Michael JiangKPMG in ChinaT: +86 1085087077E: [email protected]

Sai Choy ThamKPMG in SingaporeT: +65 62132500E: [email protected]

Americas Region

Brian HecklerKPMG in the UST: + 1 312 665 2693E: [email protected]

Neal McNamaraKPMG in the UST: + 1 312 665 1638E: [email protected]

Jarib FogacaKPMG in BrazilT: +55 1921298701E: [email protected]

Grant McDonaldKPMG in CanadaT: +1 613 212 3613E: [email protected]

EMA Region

Prof. Dr. Kai C. AndrejewskiKPMG in GermanyT: +49 211 475 7900E: [email protected]

Dr. Gerhard DaunerKPMG in GermanyT: +49 89 9282 1136E: [email protected]

Glynn BellamyKPMG in the UKT: +44 121 6096170E: [email protected]

Jean Luc Guitera KPMG in FranceT: +33 155686962E: [email protected]

Laurent Des PlacesKPMG in FranceT: +33 155686877E: [email protected]

Maurizio TondoKPMG in ItalyT: +39 02676431E: [email protected]

Lydia PetrashovaKPMG in RussiaT: +7 495 9372975 E: [email protected]

mailto:[email protected]





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Publication name: New on the Horizon: Revenue recognition for Aerospace and Defense companies

Publication number: 120291

Publication date: March 2012

KPMG International Standards Group is part of KPMG IFRG Limited.

KPMG International Cooperative (“KPMG International”) is a Swiss entity that serves as a coordinating entity for a network of independent firms operating under the KPMG name. KPMG International provides no audit or other client services. Such services are provided solely by member firms of KPMG International (including sublicensees and subsidiaries) in their respective geographic areas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothing contained herein shall be construed to place these entities in the relationship of parents, subsidiaries, agents, partners, or joint venturers. No member firm has any authority (actual, apparent, implied or otherwise) to obligate or bind KPMG International or any other member firm, nor does KPMG International have any such authority to obligate or bind KPMG International or any other member firm, in any manner whatsoever.

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Revenue recognition for Aerospace and Defense companies

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