Practical Application of the New Revenue Standard

Transcription

1 Practical Application of the New Revenue Standard CBI Master Class March 17, 2015 Spring Update 2015

2 Today s Agenda Welcome and introduction Overview- The five step approach Recent developments Practical Applications Implementation Challenges Approach to conversion Revenue Playbook Project Preparedness and Contract Review 2 2

3 Introductions Pamela Yanakopulos, Partner, Joseph Braido III, Director, 3

4 Overview The five step approach 4

5 Steps to apply the new revenue recognition standard $ $ Step 1: Identify the contract(s) with the customer Step 2: Identify the separate performance obligations in the contract(s) Step 3: Determine the transaction price Step 4: Allocate the transaction price The new standard proposes a 5 step model to determine revenue recognition, which completely replaces existing US GAAP/IFRS model Principles based model Not a one-for-one comparison to current US GAAP/IFRS All contracts with customers will need be evaluated under the new model Step 5: Recognize revenue when (or as) a performance obligation is satisfied 5

6 Step 1 Identify the contract All of the following criteria must be met Parties have approved the contract and are committed to perform their obligations Each party s rights regarding goods or services to be transferred can be identified Payment terms can be identified Contract has commercial substance Collection of the consideration is probable after the goods or services have transferred More on collectibility Consider only customer s ability and intent to pay amount of consideration when it is due Amount of consideration that an entity will be entitled may be less than the price stated in the contract (price concessions) If not probable, not all contract criteria are met revenue would be deferred until substantially all cash is received and no remaining obligations to perform (or contract is terminated and amounts received are non-refundable) 6

7 Step 2 Identify performance obligations Performance obligation is a promise to transfer a: Distinct good or service (or a bundle of distinct goods or services) or Series of substantially similar distinct goods or services, have same pattern of transfer to customer over time (core subscription services) Distinct Customer can benefit on its own or with other resources Promise is separable from other goods or services No significant service of integrating No significant modification or customization Not highly dependent on or interrelated with other goods or services * * (TRG update) 7

8 Step 3 Determine the transaction price Variable consideration Included in the transaction price only if it is probable [IFRS highly probable] that there will not be a significant revenue reversal Uncertainty over long period of time Limited experience with similar contracts Susceptible to factors outside control Broad range of outcomes Key considerations Performance bonuses, penalties, price concessions, rebates, returns, etc. Expected value or most likely amount Must recognise minimum amount that is probable of not reversing Reassessed at the end of each reporting period 8

9 Step 4 Allocate transaction price Transaction price allocated to separate performance Obligations based on relative standalone selling prices Maximize use of observable inputs (not necessarily a rate card ) Applied consistently across goods or services with similar characteristics Possible estimation methods include, but are not limited to: - Expected cost plus an appropriate margin - Assessment of market prices for similar goods and services adjusted for entity-specific costs and margins - Residual approach only if selling price is highly variable or uncertain Other items to consider Discounts may be allocated to bundles within a bundle Variable consideration may relate to only one performance obligation in some circumstances Key changes (US GAAP): no prescribed hierarchy, no contingent cash cap, no required VSOE (software) 9

10 Over time Step 5 When does control transfer Over time or at a point in time? Yes Customer receives benefits as entity performs/another would not need to reperform e.g. cleaning services or a subscription service Yes Yes Create or enhance an asset the customer controls e.g. house on customer land or other tangible goods under construction Does not create asset w/alternative use And Right to payment for work to date e.g. a customized data analytics solution No No No Point in time (control-based model) 10

11 Recent Developments 11

12 Effective date Update FASB performing site visits in Q and Q to assess progress and understand challenges Final decision from FASB on deferral no later than Q No comment from IASB 12

13 Board deliberations Update License of intellectual property Potential non-convergence US GAAP ASU exposure Q Brighter line classification - symbolic IP over time IFRS No specified timeline for outreach Clarify where activities affect the utility and some activities affect the value - functional IP point in time unless form/function is expected to change Clarify Royalty exception applies when predominant item to which it relates is a license (no splitting of the royalty) Clarify Incorporate BOC language when a license is combined with other goods Clarify Time, geography or use do not affect the number of promised goods/services Clarify royalty exception applies when predominant item to which it relates is a license (no splitting of the royalty) No clarification needed when a license is combined with other goods No clarification needed regarding attributes of time, geography or use 13

14 Board deliberations Update Identifying performance obligations US GAAP ASU exposure Q Clarify inconsequential/perfunctory immaterial items (in the context of the contract) need not be identified Clarify determination of distinct IFRS No specified timeline for outreach No clarification needed regarding inconsequential/perfunctory Clarify determination of distinct through additional examples - Nature of promise is to transfer each of the goods/services vs. a combined item - Don t combine when only one good/service is affecting the other - Additional examples Shipping/handling Practical expedient when S&H occurs after control transfers vs. a separate PO Outreach to determine if shipping/handling is an issue 14

15 Transition resources group Update Topics discussed to date Further analysis considered Gross vs. net revenue including taxes Contract enforceability and termination clauses Timing of noncash consideration measurement Transition guidance for contract modifications Board deliberations Performance obligations- distinct and inconsequential/perfunctory Licenses No further action proposed Customer options for additional goods and services and non-refundable upfront fees Variable considerations/consideration payable to a customer Stand-ready performance obligations Capitalization of contract costs Presentation of contract asset or a contract liability Impairment testing of capitalized contract costs Islamic financing transactions 15

16 Practical Applications 16

17 Licenses & Collaboration arrangements Complexities Identifying whether a license is distinct from other promises Determining the nature of an entity s promise in granting a license Determine when and how to apply sales & usage based royalty exception Determining the recognition model for a promise that includes a non-distinct license 17

18 Licenses- example Assumptions Pharma grants an exclusive IP license to Biotech (customer) to market and distribute ABC product and will provide manufacturing services. Per the contract terms, Pharma is the exclusive provider of the manufacturing service, although the services are not complex and could be performed by others in the market. 18

19 Licenses- example (continued) Considerations Pharma concludes the license is distinct from the manufacturing services, as: - Biotech can benefit from the license either on its own or together with other readily available resources. - Pharma s promise to provide manufacturing services is separately identifiable in context of the bundle* since: The nature of the Pharma s promise is to transfer the both license and the manufacturing services, rather than to transfer a combined item(s) to which each of the goods or services is an input Significant modifications to the underlying IP as a result of the manufacturing services performed are not expected. Pharma will then assess whether the IP being licensed is symbolic or functional*, which will impact timing of revenue recognition. *Guidance is pending the FASB s proposed exposure draft 19

20 Proposed Revenue Recognition for Distinct Licenses Functional IP- Examples Biological compounds Drug formulas Software licenses completed media content Symbolic IP- Examples Brand Team Trade names Logos Franchise rights *Guidance is pending the FASB s proposed exposure draft. Examples were extracted from the February 6, 2015 FASB Staff paper, Determining the Nature of the Entity s Promise in Granting a License; The Sales and Usage-Based Royalties Exception 20

21 Collaboration Arrangement with multiple performance obligations Example Facts: Biotech enters into agreement to license intellectual property to Pharma Co. ( License A ) and provide R&D services to Pharma related to the development of the compound associated with the IP for Pharma Co. The IP relates to a compound that does not have regulatory approval and is currently under development and entering Phase II. Biotech receives: - Upfront payment of $40M - 10% royalty on sales of a commercial product. 21

22 Collaboration Arrangement with multiple performance obligations Example (continued) Step #2: Identify separate performance obligations: Biotech determines that License A and the R&D services are distinct performance obligations because both of the following were met: - Capable of being distinct: Pharma can benefit from the license without the R&D services: License A could have been sold separate from the R&D services Pharma could have chosen to perform the research itself/hired another party - Distinct in the context of the contract: License A is separately identifiable in the context of the bundle from the other promises given that the nature of Biotech s promises is to transfer both R&D services and a license rather than a combined output*. *Guidance is pending the FASB s proposed exposure draft 22

23 Collaboration Arrangement with multiple performance obligations Example (continued) Step #3: Determine the transaction price: Biotech determines the transaction price include both fixed and variable consideration. Fixed: $40 M from the upfront payment Variable: 10% royalty on sales of a commercial product. 10% royalty on sales of a commercial product is evaluated to determine if the exception for sales and usage based royalties for licenses of IP applies - Is license predominant item to which the royalty relates is a license (no splitting of the royalty*)? If yes, exception applies. If no, exception does not apply. - The assessment of whether license is predominant applies if license and service were one performance obligation or separate performance obligations. *Guidance is pending the FASB s proposed exposure draft 23

24 Collaboration Arrangement with multiple performance obligations Example (continued) Step #4: Allocate the transaction price: The transaction price at inception is allocated on a relative fair value basis, based on the proportion of standalone selling prices of the two performance obligations - 75% to License A - 25% to R&D services (considering estimate of hours necessary +25% margin) Biotech should also determine if the royalty should be allocated to both performance obligations (allocated on same relative basis) or if attributable to only one of the performance obligations. 24

25 Collaboration Arrangement with multiple performance obligations Example (continued) Step #5: Recognize revenue when (or as) each performance obligation is satisfied : Biotech determines if the IP being licensed is symbolic or functional - Does IP have standalone functionality (ability to process transaction, perform a function or task)? If Yes, IP is functional and recognition is at a point in time, unless: There are activities that are expected to change the form and functionality of the IP (over time) and; These activities are not separate performance obligations If No, IP is symbolic, overtime recognition Based on the February 6, 2015 FASB Staff paper, Determining the Nature of the Entity s Promise in Granting a License; The Sales and Usage-Based Royalties Exception, licenses of IP common for this sector (i.e. biological compounds, drug formulas) are likely to be functional IP. 25

26 Collaboration Arrangement with multiple performance obligations Example (continued) Step #5: Recognize revenue when (or as) each performance obligation is satisfied : Biotech recognizes revenue allocated to R&D services over time (the estimated research period) - Assume that the recognition over time criteria has been met - Based on a pattern that reflects the transfer of the services as the services are satisfied continuously over the research period - Revenue recognized is then be recognized using the method that represents the best measurement of progress towards completion. 26

27 Collaboration Arrangement & Licenses Other areas of complexity include: Milestone payments - Application of the constraint guidance- nature of the contingencies - Allocation to one or multiple performance obligations Sales- and usage-based royalties - Determination whether the royalty exception applies-arrangements where fixed payments may be tied to specific sales or usage by the licensee Milestone payments determined by reference to a specific level of sales or upfront payments that are subject to claw back if certain sales or usage targets are not met License that has attributes of a sale - Determination of which item is the predominant item in a bundled arrangement Functional licenses - Evaluation of other activities that do not represent separate performance obligations 27

28 Sales to distributors Example Example: Pharma sells product to distributors with terms that are FOB shipping point (title passes at shipping point). Once shipped, the product cannot be redirected by Pharma. Product is invoiced and Pharma has a present right to payment at shipping point. Pharma arranges for the shipping and insures the product in transit to the customer. 28

29 Sales to distributors Example (continued) Considerations Pharma may make an accounting policy election* to either: - Accounting for this arrangement as two (or more) performance obligations: 1) Transfer of goods 2) Shipping - Account for the Shipping as a fulfillment cost, rather than as a promised good or service, when shipping and handling occurs after control has transferred to the customer If Shipping is accounted for as a separate performance obligation, Pharma would: - Allocate transaction price to each performance obligation using relative standalone selling price with revenue allocated to the: Product is recognized upon shipment Shipping is recognized as the obligation is satisfied over time (likely straight-line over service period) *Guidance is pending the FASB s proposed exposure draft 29

30 Transfer of Control Areas of Complexity Shipping goods before transfer of control is not a performance obligation shipping goods that you own * Insuring goods in transit, but not shipping goods may be a separate performance obligation - Consider if immaterial in context of the contract * *Guidance is pending the FASB s proposed exposure draft 30

31 Approach to conversion 31

32 The new standard will impact all parts of your organization to varying degrees Revenue Recognition Standard 1 Directly Impacted Work activities and/or roles will change Ex: Accounting, Finance, Sales Indirectly Impacted Core work or roles do not change; some alignment may be required Ex: Legal, HR, IT Need to know Stakeholders or audiences who will not be impacted, but should be kept informed Ex: Customers, Partners 32

33 IT system and data considerations Related system landscape: Understanding the breadth of potential system impact, as well as, data requirements and flows is a key driver of decisions to enable compliance with the new standard Revenue automation systems Transaction systems (order, quoting, contract processes) Invoicing, Billing and Collections Systems Revenue Models & Triggers Revenue Calculation Systems General ledger Reporting Platforms New data may be needed for estimates and triggers Getting started: Map accounting changes to technology and data Accounting policy determine technical revenue recognition accounting policy applicable Use cases create use cases to address the accounting policy Technology inventory technology environments involved or impacted Data inventory key data elements required for the use cases New processes may be needed Common challenges: Accounting changes with probable system impacts Identification of contract modifications and linking contracts Determining standalone selling price Allocation of transaction price amongst obligations Estimating variable consideration Common challenges: Other transition considerations Uncertainty of changing requirements in the standard Current-state data deficiencies Extensive manual effort potentially requiring new systems and leading to additional security/controls 33

34 Methodology phased approach Phases Impact Assessment Phase Establish governance and project communications Review current accounting policies and practices Provide training and awareness to Boston Scientific Plan & Assess Review revenue arrangements and contracts Develop reporting and disclosure requirements and identify data gaps Identify other key impacted areas (accounting, disclosure, process, systems, etc.) Analyze adoption alternatives and develop preliminary roadmap Design & Convert Implement & Embed Finalize adoption method approach (retrospective or practical expedient) Design new processes, structures, controls, data flows, system impacts, and procedures Build and test new processes and system changes Convert and test new data and reporting flows Update rollout and change management plan Update policies, procedures and controls Develop and deliver training Execute end user end to end testing Conduct mock go live Operationalize new method and disclosures (both transition and ongoing) 34

35 A well executed impact assessment is a critical first step in the conversion process Planning Fieldwork Analysis Reporting Information gathering and awareness Report results Establish Project Governance Develop Revenue Matrix Co-ordinate workshops/checklists/ surveys/etc. Desktop review/workshops/ surveys/checklists to identify potential changes to revenue and cost recognition policies Contract reviews Assessment of portfolio approach Analysis of results of desktop review and workshops Evaluation of broader impacts of potential changes Preliminary Solution Evaluation (ERP, Third- Party, Custom) Reporting Stakeholder briefings Create Roadmap Create Budget Training Plan Define the scope Analysis 35

36 What are companies doing now? Training & education Information gathering and awareness Sample contract reviews Identify and compile differences Develop roadmap Training and education are important in all business departments with a primary focus on accounting, tax and IT functions to ensure that each understand the changes and impacts proposed under the new standard. Identify potential accounting policy changes under the new standard within key business units and revenue streams to identify potential impacts to processes and systems. This will help companies formulate a roadmap and budget for the eventual implementation that may be necessary under the new standard. For key revenue streams identified, review a sample of representative contracts to understand the potential changes to revenue policies and accounting under the new standard. Compile listing of differences and review existing revenue and cost models, patterns of recognition and disclosures. Propose new revenue and cost models based of the new standard. Map accounting policy differences to processes and systems. Draft project plan for identified areas that will require updates and change based on the requirements of the new standard. 36

37 Implementation challenges 37

38 Implementation challenges Area Project Management Challenges observed Centralized or Dispersed: For diverse business units and/or locally run finance teams, balance local approach/pace/process that fits business versus uniform control/coordination at center Resources and Bandwidth: Necessity for sufficient resources at business units for identification and analysis (people have day jobs) Multi-disciplinary approach: Full engagement of cross functional teams to effectuate change - Tension between IT/systems (need time, certainty) versus policy (unresolved theory & TRG) Completeness Contract Terms: Reading (and re-reading) more contracts helps (see bandwidth above) - Unexpected terms; variability in terms more diverse then expected - Harmless terms under prior GAAP, now potentially bad in unanticipated ways Sampling Risk: Challenges to obtaining coverage for diverse revenue streams, unique contracts Information Sources: Motivations inconsistent with use for data (e.g. Sales force and concessions) Tax implications: Impact of new revenue standard on pre-tax income in the different jurisdictions External Communication Involvement at the top: Simplifying complex technical uncertainty & potential system change is hard - Are we ready? How much will it cost us? What is the impact to the top line per The Street? - Risks of over-simplifying and/or too much detail uncertain guidance/practice versus need to be crisp when talking to senior management and externally 38

39 Implementation challenges (continued) Area Internal Dynamics Challenges observed Communication: Challenges with cross functional communication and expectations Clear Responsibility: Who is officially in charge of herding the cats? Project management and progress is not the same as resolving technical policy issues Competing goals: Role in organization drives motivations - Business leaders: take advantage of change and alter business and customer strategy/offering - Reporting leaders: correct application of GAAP and industry consistency/comparability - Reporting preparers, systems controls: keep current process, minimize change Conflict resolution and steering committees: How diverse is the committee (across business, or just policy)? when to meet? Issue Analysis Industry and expert perspective: Insufficient industry and expert perspective testing hypotheses Auditor involvement: early/open auditor involvement drives efficiencies (saves time and effort) and increases influence in resolving uncertain interpretations of guidance across industry (company ally) Holistic versus single feature: How to balance impacts of individual features/terms/clauses compared to overall contract and business purpose - Analogy to chemistry: same elements get different results when mixed differently 39

40 Implementation challenges (continued) Area Challenges observed Questionnaire Diversity of T&Cs: Ineffective use of questionnaire to identify different terms and conditions Sampling Risk: Insufficient survey of contracts may lead to an incomplete library of terms and conditions Diversity vs. Solution: Assumption that non-standard terms and conditions found in contracts are the same from one contract to another; one-size-fits-all solutions not useful Technology & Tools Gather > conform: Tools that collect the diverse mix of contracts, terms, features, practices are helpful; tools that drive conformity for sake of sorting or bulk analyzing struggle - Simple, practical, engaging with local business Systems Current data deficiencies: Interest or need to address preexisting system gaps while addressing new system requirements (build it twice?) Changing conclusions: Inherent uncertainty around application of standard may create challenges when accepted practice develops Competing Agendas: Need to begin system implementation vs. incomplete accounting conclusions; system flexibility to adapt to changing guidance/policy? If no, then risk/reward of going early? Deals Parallel Guidance: New and current products, contracts and business are not always designed to work with the new guidance; do current long-term deals work for both? Acquisitions and Divestitures: Acquisition and divestiture trend analysis often ignore new guidance 40

41 Revenue Playbook Project Preparedness and Contract Review 41

42 Discussion Topics Real Life Implications of Inadequate Oversight Benefits to a Compliance Program Common Causes of Misreporting Framework for Effective Contract Management Considerations for Invoking Audit Rights Technological Considerations 42

43 Real Life Implications of Inadequate Oversight Do you consider your company to have an effective approach to monitor key financial terms in your collaboration / royalty agreements? Have you been surprised by the results of audits by a collaboration partner? Have you ever been surprised by the results of audits of a collaboration partner? Does your finance / accounting team have a role in collaboration contract negotiations beyond technical accounting? 43

44 Common Contract Types Advertising Construction & development Contract manufacturing CROs Co-development Co-pay card programs Co-promotion/marketing Distribution/Wholesaler Government contracting Joint ventures & partnerships IT and other outsourcing Licensing agreements Pharmacy Benefit Manager Professional services Customer rebates Servicing Software licensing Sourcing/supply arrangements Third-party Hubs Vendor allowances & rebates 44

45 Benefits to a Comprehensive Compliance Program Increased transparency of reporting by business partners. 96% 96% of contract compliance exams identified issues related to misreporting Mitigate revenue leakage. Identify contract interpretation issues.the earlier the better. Enhanced controls to decrease risks of future errors. Learnings from the contract examination process often far outweigh immediate financial returns. 45

46 Common Causes of Misreporting Failure to dedicate appropriate resources Lack of controls over the reporting process Turnover in key finance personnel Lack of communication or coordination among various departments Ambiguous/ unclear wording in agreements Overly aggressive accounting treatments Lack of understanding of contractual obligations Simple and avoidable mathematical and clerical errors Intentional non-compliance and fraud 46

47 Common Causes of Misreporting Issues by Type of Contract Net Revenue 1 Collaboration Expenses 2 Supply Completeness Product-level focus True-up adjustments Consistency of terms Interpretation issues Overhead allocations Mathematical errors Notes: 1) Net Revenue type contracts include royalty, profit-share, etc. 2) Collaboration expenses includes sales & marketing expenses, R&D, general & administrative, etc. Legend: Area of high significance Area of medium significance Area of low/ no significance

48 Common Causes of Misreporting Contract Interpretation Issues - Examples Example 1 include direct out of pocket costs (e.g. grants, materials, animals and costs of similar nature); direct labor costs (salary plus benefits); and an overhead factor of 40%, added to the direct labor costs. Example 2 expenses incurred in accordance with an approved development plan and development costs budget approved by the Joint Steering Committee or agreed by the parties, consisting of (i) direct out-of-pocket expense incurred in performance activities (ii) the cost of personnel performing the Development Plans calculated on the basis of the annual Full Time Equivalent ( FTE ) Rate of $300,000 Example 3 all other costs not included in raw materials and labor which are directly related to manufacturing process, facility or other activities related to manufacture of the Product. Overhead shall include, but not be limited to depreciation, rent, utilities, scrap, indirect materials and supplies, glassware and other appropriate expenses 48

49 Framework for Effective Contract Management Continuous monitoring Recommend control enhancements 1.Top management buy-in 2.Program notification 3.Effective communication 4.Intelligence gathering Portfolio risk assessment Perform compliance reviews 49

50 Considerations For Invoking Audit Rights Identify issues early in contract life while dollar impact is less and partners are more willing to discuss Period at the end of agreement to address true-ups Capture initial reporting period Identify changes during contract life (contractual and evolving) 50

51 Technological Considerations Manual Homegrown Technology Dedicated Software Manual Spreadsheets can be cumbersome Time spent takes away from other responsibilities Susceptible to errors Technology Effective organization to track and monitor portfolio and obligations Provides for consistency in approach and oversight Increases accuracy

52 Q&A 52

53 Presenter Bios 53

54 Add closing statement here PricewaterhouseCoopers LLP. All rights reserved. refers to the United States member firm, and may sometimes refer to the network. Each member firm is a separate legal entity. Please see for further details.