Revenue Recognition: An Analysis of Topic 606

Transcription

1 Revenue Recognition: An Analysis of Topic 606 For Technology and Life Sciences Companies February 13,

2 Learning Objectives By the end of this webinar you will be able to: Understand the reasons behind the issuance of ASC 606 Understand the 5 step revenue recognition process under ASC 606 Understand special rules for IP licenses Apply the 5 steps to tech and life science company case studies Understand a summary of selected changes and significant areas of judgment Understand an overview of disclosure requirements 2

3 Today s Speakers Alan Langelli Partner Technology Industry Services Group Norm Snyder Consultant (Retired Partner) Technology Industry Services Group 3

4 Agenda Introduction for Topic 606 New Revenue Definition and Concepts The 5 + Step Process of Recognizing Revenue Disclosure Requirements Selected Changes and Areas of Significant Judgment Effective Date and Transition AICPA Update Next Steps 4

5 New Revenue Recognition Standard The Financial Accounting Standard Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project to clarify the principles of revenue recognitions and common revenue standard. FASB amended the Accounting Standards Codification creating a new Topic 606, Revenue from Contracts with Customers. Topic 606 supersedes ASC Topic 605 and most industry specific ASC revenue recognition guidance. 5

6 Reasons for Topic Remove inconsistencies and weaknesses in revenue requirements. 2. Provide a more robust framework for addressing revenue issues. 3. Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets. 4. Provide more useful information to users of financial statements through improved disclosure requirements. 5. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. 6

7 Polling Question One of the stated reasons for the issuance of ASC 606 was to simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. Do you think this has or will be the result for your company? A. Yes B. No C. Still not sure Other 7

8 New Revenue Definition and Concepts An entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The concepts of earnings process and realization/realizability have been eliminated. Transferring of the promised goods is essential to the timing of revenue recognition. The concept of entitled is essential to the measurement of revenue. 8

9 The Five + Step Process of Recognizing Revenue 1 Identify the Contract with the Customer. 2 Identify the Separate Performance Obligations in the Contract. 3 Determine the Transaction Price. 4 Allocate the Transaction Price to the Separate Performance Obligations in the Contract. 5 Recognize Revenue when (or as) the Company satisfies a Performance Obligation. Extra Licenses of Intellectual Property (Special Rules) 9

10 Step 1: Identify the Contract(s) A contract is an agreement between two or more parties that creates enforceable rights and obligations. May be written, verbal or customary (implied by entity s normal business practices). A contract does not exist if both parties can cancel an agreement without penalty when it is wholly unperformed. The rights and obligations must be enforceable may be a matter of law and may vary within industry and jurisdiction. 10

11 Step 1: Identify the Contract(s) Requirements for a contract: Approval and commitment of the parties. Identification of the rights of the parties. Identification of the payment terms. Contract has commercial substance. It is probable that the entity will collect the consideration to which it will be entitled. If all criteria above are not met, the 5 step recognition model is not followed and no revenue is recognized until the arrangement is fully resolved. 11

12 Step 1: Identify the Contract(s) Combining Contracts: Certain contracts should be combined if: Entered into at or near same time with same customer. And one or more of the following is met: Contracts are negotiated as a package with a single commercial objective, or Consideration to be paid in one is dependent on price/performance in the other, or Goods and services promised are a single performance obligation. Probable of collection: Probable is generally interpreted as 75-80% in U.S. GAAP. Probability assessed after reducing for any expected price concessions. Price concessions are variable consideration and not a factor to consider in assessing collectibility. Consider ability to mitigate credit risk by ceasing to provide goods or services for non-payment. 12

13 Step 1: Identify the Contract(s) Contract Modifications: Contract modification is a change in scope or price (or both). Must be approved by both parties (ignore until approved). Account for as a separate contract if: Scope increases due to addition of distinct goods or services, and price change reflects standalone selling prices. Termination of existing contract and creation of new contract (prospective recording) if: Remaining goods/services are distinct from those already transferred but price change does not reflect standalone selling prices. If not distinct and does not reflect standalone selling prices, treat as part of existing contract (cumulative catch-up adjustment). 13

14 Step 1: Example 4 from ASC Topic 606 Subsequent collectability- patent license usage royalties : Biotech A entered into an agreement to license a patent to Pharma B in exchange for a useagebased royalty. At inception the agreement meets the criteria for a contract including probability of collection. At inception, Biotech A plans to recognize the revenue when the subsequent usage occurs under the license of IP rules (different from variable consideration rules). In year 1 Pharma B provides usage reports and pays as agreed. In year 2 Pharma B s financial condition declines. It pays Q1 royalties on time but makes nominal payments in Q2-4. Biotech A continues to recognize the royalty revenue as usage occurs in year 2 but evaluates the receivable for impairment. In year 3, Pharma B loses access to credit and its major customers and its ability to pay significantly deteriorates. Biotech A concludes it is unlikely future royalty payments will be received. Biotech A concludes the criteria for a contract are no longer met because it is no longer probable it will collect the consideration to which it will be entitled. Biotech A does not recognize any further revenue. 14

15 Polling Question Assume a software company enters into a new market that is currently experiencing economic stagnation and enters into an arrangement with a start-up customer that has limited capital. Do you think collection is probable and this should be treated as a contract at inception? A. Yes B. No C. Undecided or Other 15

16 Step 2: Identify Performance Obligation(s) A promise to transfer a good or service to a customer: Can be: Explicitly stated or Implied by the entity s customary business practice. Is identified at contract inception. Examples of promises in software arrangements that could be separate performance obligations include: multiple licenses, unspecified or specified future updates or upgrades, SaaS or subscription services, provision of hardware, specified or unspecified additional software products, exchange rights, PCS, installation, customization, training, etc. 16

17 Step 2: Identify Performance Obligation(s) Is a separate performance obligation, or a series of distinct goods or services that are substantially the same that can benefit the customer. Distinct = capable of being distinct and distinct within the context of the contract. Capable of being distinct = customer can benefit on its own or with other resources readily available to the customer. Context of contract = no significant integration or goods/services, not highly interrelated. Benefit the customer = can be used, consumed, sold for > scrap or held to generate economic benefits. 17

18 Step 2: Identify Performance Obligation(s) Special rules for licenses of intellectual property: Licenses of IP differ in some respects from the guidance for other goods and servicesespecially as it relates to sales based royalties. Is it a license for IP (on-premises software vs. hosted arrangements; does the customer have the right to take possession of the software and run the software on its own hardware)? Is the license distinct? Same criteria as before (capable of being distinct and distinct within the context of the contract). Is it right to use ( functional ) IP or right to access ( symbolic ) IP? Functional IP includes software licenses and patents. Symbolic IP includes brands and trade names. Revenue from functional IP is generally recognized at a point in time (when it grants the right to use IP as it exists at a point in time). No revenue until functional IP transferred and beginning of license term. Revenue from symbolic IP is generally recognized over time. Revenue from sales and usage based royalties for distinct IP licenses is not recognized until the sales or usage occurs and the performance obligation has been satisfied (in whole or in part). Different from the general ASC 606 variable consideration guidance. 18

19 Step 2: Identify Performance Obligation(s) Additional considerations for licenses of intellectual property: Options to renew or extend licenses are not included in the original contract term. Options to renew/extend is a separate performance obligation if it provides a material right the customer would not receive without entering into the original contract. Option to renew at a discounted price may be a material right if different from the range of discounts typically given to other customers. A cancellation right to allow customer to cancel multi-year contract after each year should be the same as a one year contract with a renewal option. Can t recognize revenue from a license renewal until the renewal term starts. Generally, the software license and PCS will each be distinct if the software is functional without the PCS (even if mandatory under the agreement). Unspecified updates/upgrades may not be distinct if critical to continued utility of the software. Software companies will need to evaluate whether specified upgrade rights represent distinct goods/services from the basic license. 19

20 Step 2: Example 10 C from ASC Topic 606 Software and Updates not separate performance obligations: Software Company A grants a 3 year term license for anti-virus software to a customer C to provide when-and-if available updates to the software during the license period. Company A frequently provides updates that are critical to the continued utility of the software. Without the updates C s ability to benefit from the software would decline significantly over the license term. Company A concludes the software and the updates are each promised goods or services that are each capable of being distinct. Company C can derive economic benefit from the software on its own throughout the license period (that is, without the updates the software would still provide the original functionality), while Company C can benefit from the updates together with the software license that is transferred in the beginning. However, A concludes the promises to transfer the software license and to provide the updates are not separately identifiable because the license and the updates are inputs to a combined item (anti-virus protection) in the contract. Therefore, in this example, the software and the updates are treated as a single performance obligation. 20

21 Step 2: Example 11 A from ASC Topic 606 Software, installation and technical support are separate performance obligations: Software Company A contracted with Customer C to transfer a software license, perform an installation service and provide unspecified software updates and technical support (online and telephone) for a two-year period. Company A sells the license, installation service and technical support separately. The installation service is routinely performed by other entities and does not significantly modify the software. The software remains functional without the updates and the technical support. Company A concludes that Company C can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available. Company A also concludes the promise to transfer each good and service is separately identifiable from the other promises. Company A determines the installation services do not significantly affect Company C s ability to benefit from the software license because the installation services are routine and can be obtained from other providers. The software updates do not significantly affect Company C s ability to benefit from the software license because they are not necessary for Company C to maintain a high level of utility during the term. Company A concludes the promised goods or services do not significantly modify one another and are not highly interrelated. Company A identifies 4 performance obligations: software license, installation service, software updates and technical support. 21

22 Step 2: Example 11 B from ASC Topic 606 Software, installation with significant customization are not separate performance obligations: Software Company A contracted with Customer C to transfer a software license, perform an installation service with significant customization and provide unspecified software updates and technical support (online and telephone) for a two-year period. Same as 11 A except includes significant customization to add functionality to enable the software to interface with other customized applications used by Company C. The customized installation services can be provided by other entities. Company A concludes all of the promised goods and services are capable of being distinct. However, Company A observes the terms of the contract require Company A to use the software with the customized installation service to produce a combined output. Company A concludes the promise to transfer the license is not distinct from the customized installation services in the context of the contract. Company A concludes there are 3 performance obligations: customized software (license and customized installation), software updates and technical support. 22

23 Step 2: Example 11 C from ASC Topic 606 Equipment and installation are separately identifiable: Health IT Company A sells a piece of equipment and installation services to Customer C. Equipment is operational without any customization or integration and the required installation is not complex and is capable of being performed by other service providers. Company A concludes the two promises are capable of being distinct since the equipment can be used together with other readily available recourses (could buy installation elsewhere) and Company C benefits from the installation together with resources it has already obtained (the equipment). Company A also concludes the promises are separately identifiable (distinct within the context of the contract) since the equipment and the installation services are not inputs to produce a combined item in this contract. Company A concludes there are 2 performance obligations in the contract: the equipment and the installation services. 23

24 Step 2: Example 11 E from ASC Topic 606 Equipment and consumables are separately identifiable: Health IT Company A sells a piece of non-customized equipment and specialized consumables to Customer C at predetermined intervals over three years. The consumables are produced only by Company A but are sold separately by Company A. Company A determines that Company C can benefit from the equipment together with readily available consumables since they are regularly sold separately by Company A to customers that had previously purchased the equipment. The equipment and the consumables are each capable of being distinct. Company A concludes the equipment and the consumables are separately identifiable since there is not a significant integration service. Company A concludes there are 2 performance obligations in the contract: the equipment and the consumables. 24

25 Step 2: Example 56 A from ASC Patent License and Drug Manufacturing Are Not Distinct: Pharma A licenses to Customer C its patent rights to an approved drug for 10 years and also promises to manufacture the drug for Company C for 5 years while Company C develops its own manufacturing capability. The drug is mature and there is no expectation for Company A to undertake activities to change the drug. In this case, no other company can manufacture this drug for Company C because of the highly specialized nature of the manufacturing process. The license cannot be purchased separately from the manufacturing service. Since Company C cannot benefit from the license without the manufacturing service, the license and the manufacturing service are not distinct. Company C accounts for this as a single performance obligation. Although the patent license is for 10 years, Company C retains solely the right to use the functional IP during years 6-10 and no further performance is required of Company A. Thus all of Company A s performance under the contract will be completed after year 5. A will need to evaluate whether its performance obligation is satisfied at a point in time or over time. 25

26 Polling Question Assume the facts and conclusions stated in Example 56A where the patent license and drug manufacturing were not distinct. When do you think the revenue should be recognized? A. All at the end of 5 years B. Over time from beginning through year 5. C. Over time from beginning through year 10. D. Undecided or other 26

27 Step 2: Example 61 B from ASC Topic 606 Right Use IP- Distinguishing Multiple Licenses from Attributes of a Single License: Biotech company A enters into a license contract with Customer C that permits Company C to use functional IP for 5 years. Beginning with the first year, Company C is permitted to use the IP only in its research activities. Beginning with the second year, Company C is also permitted to use the IP to produce a product for sale to its customers. There is no expectation that Company A will undertake any activities to change the functionality of the IP during the license period. A makes the IP available to Company C at the beginning of the first year. Does this represent one or two performance obligations? Company A determines the right to use the IP in research and the right to use the IP in product production are distinct from each other since Company C can benefit from each on its own and independently of the other. There is no integration service provided, neither right significantly modifies or customizes the other, and Company A can fulfill its promise to transfer either right without transferring the other right. Since the two rights are distinct, Company A concludes there are two performance obligations and that each is satisfied at a point in time. Company A determines it should recognize the revenue related to the research activities at the beginning of the first year and for the product production at the beginning of the second year. 27

28 Step 3: Determine the Transaction Price Transaction price is the amount of consideration to which the selling entity expects to be entitled. Terms of the contract and customary business practices should be considered. Assume the goods and services will be transferred to customer as promised. 28

29 Step 3: Determine the Transaction Price Issues to consider: Variable consideration and constraint. Significant financing components. Noncash consideration. Consideration payable to a customer. 29

30 Step 3: Determine the Transaction Price Variable consideration: Variable consideration may be a result of liquidated damages, discounts, claims, rebates, refunds, credits, incentives, performance bonuses/penalties, royalties, price concessions, rights of return or similar items. Estimate the transaction price using either the expected value or the most likely amount (whichever method is the best predictor). Expected value = sum of probability-weighted amounts in a range of possible amounts. Most likely amount = the single most likely amount from two or more possible outcomes. Consider all information reasonably available in making and updating the estimate. 30

31 Step 3: Determine the Transaction Price Constraint on variable consideration: Include variable consideration only to the extent that it is probable a significant reversal of cumulative revenue recognized will not occur when the uncertainty is resolved. Consider the following: Variable consideration is highly susceptible to factors outside entity s influence such as volatility in market, third party actions, weather, high risk of obsolescence. Uncertainty will not be resolved for a long period of time. Entity s experience with this type of contract is limited and of little predictive value. Entity has practice of broad range of concessions. Contract has large number of possible consideration amounts. 31

32 Step 3: Determine the Transaction Price Significant financing components: Is there a significant financing component in the contract? Consider anticipated time frame between transfer and payment. Consider interest rate in contract and prevailing interest rates in market. If yes, discount rate should reflect what a separate financial transaction between parties at the contract inception and reflect characteristics of the party receiving the goods or services. 32

33 Step 3: Determine the Transaction Price Noncash consideration: Is there noncash consideration? Measure at fair value of noncash consideration received. If can t reasonably estimate fair value, measure indirectly by reference to standalone selling price of goods/services to be delivered. If assets are contributed by customer to facilitate fulfillment of contract, treat as noncash consideration received if entity receives control over the assets. 33

34 Step 3: Determine the Transaction Price Consideration payable to a customer: Is there consideration payable to the customer? If paid for a distinct good, treat as a purchase in the ordinary course of business. If not paid for a distinct good, treat as a reduction of the transaction price and revenue. 34

35 Step 3: ASC Topic 606 Example 30 Advance Payments- Possible Significant Financing Component: Tech Equipment Manufacturer A enters into a contract with Customer C to sell an item of equipment and also to provide telephone technology support and repair coverage for 3 years. Company C purchases the support at the same time it buys the equipment and pays an additional amount for the support service. Customers buying the support service must pay for it upfont and a monthly payment option is not available. To determine whether there is a significant financing component Company A considers the nature of the support service and the purpose of the upfront payment. Company A requires the upfront payment because otherwise the customers would be less likely to renew if they haven t needed the support service very much. Customers who renewed and paid monthly would make greater use of the support service. Company A concludes the upfront payment was structured primarily for reasons other than providing financing to Company A and therefore that it is not a significant financing component. 35

36 Step 3: ASC Topic Example 60 Sales-Based Royalty License of IP and Other Goods and Services: Movie distribution company A licenses a Movie (IP) to Customer C to use for 6 weeks. Additionally, Company A will provide certain items at the beginning and sponsor radio ads during the 6 week period. As the compensation, Company A will receive a portion of Company C s ticket sales from showing the Movie. The question here is whether the special salesbased royalty rules for licenses apply or whether the general variable consideration rules apply. Company A concludes this is the license of IP where the license of the IP is the predominant item to which the royalty relates. Thus, A will recognize the royalty revenue as the ticket sales occur during the license period. 36

37 Polling Question If your company has contracts that include variable consideration, what type are they? A. Usage based royalty predominantly related to a functional IP license (recognize as usage occurs) B. Royalties or other variable consideration not related to a functional IP license (estimate in front as part of transaction price subject to the constraint) C. Both a. and b. D. Undecided or other 37

38 Step 4: Allocating the Transaction Price Allocation of the transaction price of a contract to the contract s separate performance obligations is: Determined at contract inception. Applied to goods / services underlying each separate performance obligation. Analyze standalone price if performance obligation sold separately. Start with actual observable price, if available. Estimate using observable inputs if observable price not available. Approaches to estimating: Adjusted market assessment approach- estimate the price a customer would be willing to pay for the separate performance obligation. Expected cost plus margin approach. Residual approach if standalone selling price is highly variable or uncertain. 38

39 Step 4: Allocating the Transaction Price Is sum of standalone selling prices for each performance obligation greater than the total transaction price (discount)? Generally allocate discount to separate performance obligations proportionally unless the observable selling prices provide evidence to where the entire discount belongs. Is there variable consideration? Generally allocate the variable consideration to the distinct goods/services to which it relates. 39

40 Step 4: ASC Topic 606 Example 35 A Variable Consideration Allocated Entirely to One Performance Obligation: Biotech A enters into an agreement with Customer C for two IP licenses, X and Y. A determines each IP license is a separate performance obligation with each satisfied at a point in time. The normal standalone selling prices of licenses X and Y are $800 and $1,000 respectively. The contact has a fixed price of $800 for license X and a 3% royalty of product sales generated due to license Y for the use of license Y. For purposes of allocation, Company A estimates the sales based royalties (variable consideration) to be $1,000. Company A concludes the variable consideration royalties should be allocated entirely to license Y for the following reasons: a. the variable consideration relates specifically to an outcome from the performance obligation to transfer license Y, and b. Company A s estimate of the sales based royalties of $1,000 approximates the standalone selling price of Y and the contract price for X approximates its standalone selling price. When Company A transfers license Y it doesn t immediately recognize any revenue. Company A will recognize revenue for the sales based royalty when the subsequent sales occur. 40

41 Step 4: ASC Topic 606 Example 35 B Variable Consideration Allocated to Several Performance Obligations: Similar facts to Example 35 A except the contracts has a fixed price of $300 for license X and a 5% royalty of product sales generated due to license Y for the use of license Y. For purposes of allocation, Company A estimates the sales based royalties (variable consideration) to be $1,500. Company A considers whether the variable consideration royalties should be allocated entirely to license Y. As in 35 A, the variable consideration relates specifically to an outcome from the performance obligation to transfer license Y, but Company A s estimate of the sales based royalties of $1,500 does not approximates the standalone selling price of Y and the $300 contract price for X does not approximate its standalone selling price. Accordingly, Company A allocates the consideration different from the amounts provided in the contract. Company A allocates the consideration based on the relative standalone selling prices. Since the sales based royalties for IP should be recognized as the sales occur, Company A recognizes $167 ($1,000/$1,800 X $300) when Y is transferred and $133 when X is transferred. As the sales occur, the royalties are recognized and allocated to Y and X in the same proportions. 41

42 Step 5: Recognizing Revenue Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that asset. Transfer of control is determined on the basis of indicators. Control refers to the ability to direct the use and obtain substantially all of the remaining benefits. Benefits are the potential cash flows that can be obtained directly or indirectly. Control includes the ability to prevent other entities from directing the use of and obtaining benefits from the asset. 42

43 Step 5: Recognizing Revenue Indicators of Transfer of Control: The seller entity has a right to payment for the asset. The customer has legal title to the asset. The seller entity has transferred physical possession of the asset. The customer has the significant risks and rewards of ownership of the asset. The customer has accepted the asset. 43

44 Step 5: Recognizing Revenue For each performance obligation identified, determination must be made at inception as to whether satisfaction is: Over Time - by transferring control of a promised good/service over time, or A Point in Time - if the performance obligation is not satisfied over time, the performance obligations is satisfied at a point in time. 44

45 Step 5: Recognizing Revenue An entity transfers control of a good/service over time and satisfies a performance obligation and recognizes revenue over time if one of the following criteria is met: The customer simultaneously receives and consumes the benefits as the entity performs, or The entity s performance creates or enhances an asset that the customer controls as the asset is created or enhanced, or The entity s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. Related definitions: An asset does not have an alternative use if the seller entity is restricted contractually or practically from redirecting the asset to another use (including selling to another customer). Right to payment considers the idea of an enforceable right to payment for performance completed to date - does not need to be for a fixed amount. 45

46 Step 5: Recognizing Revenue Performance obligations satisfied over time are recognized by measuring progress towards completion if reasonably measurable. Method used should be consistent for a performance obligation. Select a method that best depicts performance for each performance obligation. Output methods: direct measurement of the value to the customer for transfers to date (surveys of performance, milestones, units delivered, etc.). Input methods: recognized based on effort to satisfy (costs incurred, labor hours, etc.). 46

47 Step 5: ASC Topic 606 Example 13 Customer Simultaneously receives and Consumes the Benefits: Payroll Company A enters into an agreement with Customer C to provide monthly payroll process services for 1 year. The payroll processing services are accounted for as a single performance obligation. The performance obligation is satisfied over time because Company C simultaneously receives and consumes the benefits of Company A s performance in processing each payroll transaction as and when the transaction is processed. Company A recognizes revenue over time by measuring its progress toward complete satisfaction of its performance obligation using an appropriate method. 47

48 Step 5: ASC Topic 606 Example 15 Aerospace Company A enters into contract with Customer C to build a specialized satellite. Company A builds satellites for various customers, both commercial and government. The design and construction of each satellite differs substantially depending on the customers needs. As the satellite is built, Company A has the enforceable right under the contract to receive payment for performance completed to date. At contract inception, Company A considers whether its performance obligation to build the satellite is a performance obligation satisfied over time. Company A considers whether the completed satellite will have an alternative use to Company A. Although the contract does not preclude Company A from selling the satellite to another customer, Company A would incur significant costs to rework the design and function of the satellite to sell it to another customer. Company A concludes the asset has no alternative use to Company A. Thus, Company A concludes that its performance obligation to build the satellite is satisfied over time. 48

49 Step 5: ASC Topic 606 Example 54 Software License is Functional IP- Point in Time Recognition: Same facts as in ASC Topic 606 Example 11 A where it was concluded there were 4 performance obligations: software license, installation services, software updates and technical support. Company A concludes the software license represents functional IP since the software has significant standalone functionality. Company A further concludes that while the software functionality will change during the license period due to future development efforts, the functionality will change only as a result of Company A s promise to provide whenand-if available software updates that represent an additional promised service. Company A concludes that Company C has the right to use the software as it exists at the point in time the license is granted. License revenue is recognized when the license is granted and the term begins. 49

50 Step 5: ASC Topic 606 Example 55 IP License Over Time Recognition: R&D Company A licenses IP to Customer C for 3 years to use in the design and production process for tangible equipment. The contract calls for Company C to receive any updates to the IP for new designs or production processes that may be developed by Company A. The updates are integral to Company C s ability to derive benefit from the license during the license term because the technology in Company C s industry changes rapidly. Although Company C can derive benefit from the license on its own without the updates, the benefit is significantly limited and the license and the promise to provide expected updates are, in effect, inputs that together fulfill a single promise to deliver a combined item to Company C. The license and the when-and-if updates are not separately identifiable in this case. Company A concludes that Company C simultaneously receives and consumes the benefits of Company A s performance as it occurs so the performance obligation is satisfied over time. Company A concludes that a time based input measure is appropriate since based on its history, Company A anticipates its efforts to develop and transfer the updates will be generally even over the 3 year term. 50

51 Step 5: ASC Topic 606 Example 59 A IP License of Functional IP Point in Time Recognition: Recording Company A grants a license to a recorded symphony by a noted orchestra to Customer C. Company C receives the right to use the recording in commercials for 2 years in exchange for a fixed payment of $10,000 per month. The contract is non-cancellable. Company A determines its only performance obligation is to grant the license that provides Company C with the right to use the IP as it exists at the point in time when the license is granted. The recording has significant standalone functionality because the recording can be played in its present, completed form. The nature of the license IP is functional. Revenue would be recognized at a point in time, when the license is granted and the term begins. Because the payments are made over time and the performance obligation is met in the beginning, Company A would also need to evaluate whether a significant financing component exists. 51

52 Step 5: ASC Topic 606 Example 59 B Renewal of License of Functional IP Point in Time Recognition: This is a renewal of the license in Example 59 A. At the end of the year 1 of a 2 year functional IP license for the recorded symphony, Company A and Company C agree to extend the license for two additional years (years 3 and 4). The terms remain the same at $10,000 per month. Company A considers this apart from the original contract since the renewal is not entered into around the same time. Company A considers whether it should be treated as a new license or a modification of the original license. Assuming the price for the renewal reflects the standalone selling price, Company A will account for the renewal as a separate contract. If the price for the renewal does not reflect the standalone selling price, Company A will account for the renewal as a modification of the original license contract (with prospective adjustment since the renewal is distinct). Since Company C cannot use and benefit from the license extension before the beginning of the two year renewal period, revenue related to the renewal cannot be recognized before the renewal period begins. As in Example 59 A, A would also need to evaluate whether a significant financing component exists. 52

53 Step 5: ASC Topic 606 Example 61 License to Access to Intellectual Property: Professional sports team A licenses the use of its name and logo to Customer C. Company C has the right to use the logo on its products for one year. A will receive fixed consideration of $2 million plus a royalty of 5 % of the sales price of items sold using the name or logo. Company A concludes the only performance obligation is the license. Does the license provide Company C with a right to access Company A s intellectual property or with a right to use Company A s intellectual property? Company A concludes the IP is symbolic IP since the utility to Company C is derived from A s past and ongoing successful activities that give value to the IP. Absent the successful activities, the IP would have little or no utility to Company C because they have no standalone functionality. Thus, this is a right to access the IP throughout the license period and Company A will account for this as a performance obligation satisfied over time. Company A concludes it should recognize the fixed consideration ratably over the license term since the IP is symbolic IP and should recognize the royalty fees as Company C sales occur since the sales based royalty relates solely to the license that is the only performance obligation in the contract. 53

54 Polling Question For your company, which of the 5 steps will likely involve the most judgment and/or be the most difficult to determine? A. Step 1 (Identify contract) B. Step 2 (Identify performance obligations) C. Step 3 (Determine transaction price) D. Step 4 (Allocate transaction price) E. Step 5 (Recognizing the revenue) F. Undecided or other 54

55 Disclosure Requirements Extensive disclosure requirements in order to help the users understand the nature, amount, timing, risks and judgments related to revenue recognition and cash flows. US GAAP only -- Provides simplified options for Nonpublic companies that can reduce some of the quantitative disclosures for disaggregation of revenue, etc. Significant New Disclosures will include: Revenue disaggregated according to the timing of transfer of good or services (i.e. revenue recognized at a point in time versus over time). Contract assets, liabilities and receivables. Accounting policy elections, to include: governmental taxes assessed and shipping/handling costs. Performance obligations, to include: when satisfied, payment terms, nature of the goods and services to transfer, obligations for returns, types of warranties and revenue recognized from obligations satisfied or partially satisfied in prior periods. Effective date and Transition disclosures will depend on if you choose the full retrospective approach or the modified retrospective approach. 55

56 Selected Changes from Previous Standards A contract is an agreement with a customer that creates legally enforceable rights. It may be either verbal or written. ASC 606 is less driven by the form of the arrangement. (Step 1) Collectibility assessed to determine if there is a contract. Under old rules, collectibility was a constraint on revenue recognition. (Step 1) Under old revenue recognition rules for software, extended payment terms > 1 year generally precluded recognition (presumption was that it was not fixed). Under new rules extended payment terms considered in whether there is a contract (Step 1) and in estimating the transaction price (Step 3). Revenue may be recognized sooner under new rules. Under new revenue recognition rules, cash-basis method cannot be used if collectibility not probable. (Step 1) How to identify separate performance obligations is significant change for software industry - VSOE no longer required. (Step 2) Characterization of software licenses as right to use IP may significantly accelerate revenue (Steps 2 and 5) Revenue related to IP license renewal may be recognized later than old rules since renewal period will have to start first. 56

57 Selected Areas of Significant Judgement Estimating collectibility and expected price concessions. (Step 1) Is the promised good or service distinct? (Step 2) Estimating transaction price that is expected (probable) to be received especially when variable consideration is involved. (Step 3) Estimating standalone selling prices for separate performance obligations. (Step 4) Determining whether control is transferred over time or at a point in time. (Step 5) For over time recognition, estimating the progress toward completion. (Step 5) 2018 All Rights Reserved Aronson LLC Slide: 57

58 Effective Dates of Topic 606 Update Revenue from Contracts with Customers (Topic 606): Deferral of Effective Date This ASU deferred the effective date of ASU for one year. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance of ASU to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. For all other entities Update applies to annual reporting periods beginning December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, All other entities may early adopt Update for reporting periods beginning after December 15,

59 Transition Methods for Topic 606 Full Retrospective: Restate for all contracts for all prior years presented in financials. Full Retrospective using one or more practical expedients. Practical expedients relate to variable consideration, modified contracts, etc. Cumulative Effect: Record cumulative effect to opening retained earnings at date of adoption. 59

60 AICPA Update 6 Subsequent Accounting Updates since issued AICPA Task Force 16 Industries Software Industry Still working through the following issues: Customer options to purchase additional copies of software Transfer of control of a software license Estimating standalone selling prices including the use of a range Determining whether other goods or services in a software arrangement are separate performance obligations AICPA Guide has been initially issued and is being updated with new decisions. 60

61 Next Steps Time is Short Establish a project team and develop a project plan and timeline Diagnostic or assessment phase Review sample of contracts and current accounting policy to identify gaps. Identify new information requirements (estimates, calculations, journal entries, disclosures, etc.). Identify changes needed to financial processes and systems Solution design phase Detailed contract reviews Develop new accounting policies Design changes to processes, systems and controls Design disclosure data collection processes and systems Finalize implementation plan Implementation Aronson can help 61

62 Polling Question Where is your company in the process of implementing the standard now? A. Establishing team and plan B. Assessment phase C. Solution design D. Implementing the solution E. We are fully implemented F. Undecided or other 62

63 Questions? 63