Memorandum Issue Date September 2012 Project Topic Revenue from Contracts with Customers Summary of user outreach The following summarizes user outreach conducted with analysts and investors that cover sectors the staff think could have a material reporting change from the board s proposals in the revised Exposure Draft, Revenue from Contracts with Customers. The summaries are not inclusive of all user outreach conducted. For example they do not include feedback received during user group meetings (such as ITAC, CFA Institute, CRUF, etc), webcasts, speeches, roundtables or other group forums. This summary outlines feedback from approximately 70 meetings, phone calls and emails from individual users and firms that the staff conducted direct outreach with during the comment period and are meant to be read in tandem with the comment letter summary and other summarized feedback materials. The sectors include: Software/technology, telecom, media/entertainment, asset managers and financial services. Software & Technology Outreach Summary of outreach conducted The staff discussed the following topics with all of the analysts: o The ED s impact on accounting for software arrangements with multiple deliverables particularly those arrangements where revenue is recognized ratably over time under current U.S. GAAP because the entity does not have vendor specific objective evidence ( VSOE ) of the fair value of the deliverables o The ED s impact on entities that sell products through distributors and currently recognize revenue on the sell through basis of accounting (i.e. revenue recognition is delayed until the product is sold to the end retail customer) The staff discussed the following topics with some of the analysts: o Disclosures o The reasonably assured constraint on collectability in existing U.S. GAAP Software arrangements with multiple deliverables Overall views of the proposed changes were mixed between favorable and unfavorable
The majority of users stated that current accounting could be improved by requiring disclosures of contract backlog and billings instead of changing revenue recognition for the industry Analysts who were in favor of the proposed changes to existing VSOE guidance made the following comments: o Ratable revenue recognition under current U.S. GAAP for software contracts with licenses makes it hard to determine whether the revenue is attributable to the license, the service, or the support. The proposed model will allow management to make this distinction, which will result in revenue recognition that is a better match of the economics of the contract o It is difficult to understand what is driving deferred revenue under current U.S. GAAP because deferred revenue commingles new and existing contracts o Under existing guidance, companies can structure contracts to defer revenue recognition based on whether products are bundled o Removal of the existing VSOE requirement would not cause substantial concerns as long as preparers apply the model consistently from year to year and auditors can objectively audit this information Analysts who were not in favor of the proposed changes to existing VSOE guidance made the following observations: o It will be easier for management to manipulate estimates of standalone selling prices of each deliverable in order to achieve a desired pattern of revenue recognition The best solution to this problem is to retain ratable revenue recognition guidance when the company does not have VSOE o The proposed model seems to create additional complexity because it will be hard for analysts to determine how much revenue is being allocated to each deliverable o It is too easy to manipulate revenue recognition under the proposed model o It will be extremely difficult to strip out nonrecurring cash flows from recurring cash flows o Companies could allocate revenue inconsistently Sell-in versus the sell through method of recognizing revenue All of the analysts except for one preferred existing guidance that requires a vendor to recognize revenue as sales are made by resellers or distributors (i.e. on a sell through basis) when certain conditions are met rather than the proposed model s revenue constraint The analysts who preferred existing revenue recognition guidance made the following observations: o Historically, many companies that recognize revenue when products are sold to distributors (i.e. the sell-in method) have proven to have unfavorable ramifications with returns, steep unforeseen price changes, and channel stuffing o Companies may channel stuff their products and it should be clear that the final customer has taken ownership and risk of the final product before revenue is recognized Page 2 of 9
o The sell through method in existing U.S. GAAP lessens fears of channel stuffing and the need for additional analysis of what is still in the distribution channel o It is often impossible to determine the price of a transaction because of the practice of deep and inconsistent discounting o The sell through method is more meaningful and provides the right incentives for operating the business o Disclosures about channel inventory are relatively poor o The sell through method is cleaner and matches end customer demand o The sell in method is subject to the working capital demands of distributors The analyst who preferred eliminating the sell through method had the following observations: o The analyst would rather have a single method used and believes it would be easier for companies to use the sell in method o Companies should have the ability to estimate variable consideration for price concessions, rebates, etc. o Those companies that use the sell through method have a very consistent gross margin, which may imply that it is easier to manage earnings under this method o For companies that use the sell through method, analysts wonder what is being held in the distribution channels Reasonably assured constraint on collectability in existing U.S. GAAP All of the analysts favored retaining existing guidance in U.S. GAAP requiring that collectability be reasonably assured before recognizing revenue o The problem with recognizing revenue when collectability is not reasonably assured is that management can t make a good estimate of bad debt expense o The proposed model s guidance on collectability may complicate financial analysis o Collectability issues could become more common if existing guidance changes Feedback on disclosures Analysts recommended the following disclosures in response to the proposed revenue recognition changes for the software and technology industries: o Quantitative information about billings, including product license billings, maintenance billings, and service-related billings because it is difficult to break these out when revenue is recognized ratably under existing guidance o New billings versus renewal billings o Annualized bookings that is standardized to promote reporting consistency o The term length of billings so that it is easier to predict when revenue will be recognized o The annual contract value of contracts signed each quarter Page 3 of 9
Summary of Telecom User outreach conducted Users believe there will be inconsistency between companies in estimating the standalone selling prices for both phones and services o Currently, there are not active markets for buying handsets and services separately o The pricing and packages are variable over time and by customer o The proposal will make it difficult to determine the amount that customers are paying the carrier for handsets and services Users believe current accounting is reflective of the economics of the Telecom business o Phone subsidies/discounts that are provided to the customer are viewed as acquisition costs and users try to analyze the service business on a standalone basis o Handset subsidies and how they change over time are transparent in the current model o A few users indicated that the proposal makes sense from a theoretical perspective, but in practice management judgment will create issues with comparability Some users highlighted that it will be more difficult to calculate free cash flow from operations because actual revenue is not reflective of current cash inflows Users stated that the proposal is trying to fix the wrong problem o Current accounting and disclosure does not provide visibility into the expense structures of Telecom companies Key metrics that users are concerned will be altered include: ARPU (average revenue per user), service margins, monthly recurring expenses and one-time cost per gross add User suggested the following improvements to existing presentation and disclosures: o The cost of equipment should be presented separately from cost of services in the income statement o Subsidies for new versus existing customers o Investors would like additional disclosures and consistency around total equipment cost, equipment expense, costs to acquire customers and further breakdowns of expense allocated for new vs. existing customers A couple of users supported the proposed model and thought it would provide better information about the economics of the business, particularly when companies offer different subsidies for the same phone Page 4 of 9
Media and Entertainment Outreach Summary of outreach conducted The staff asked users about the proposed changes to accounting on the timing and amount of revenue recognition for companies that engage in television barter transactions Majority view (roughly 80%)- prefer current accounting Users believe the proposal will add management assumptions that will ultimately require true-ups to the upfront estimates o Companies will be forced to make estimates on advertising that has not yet run and is subject to significant volatility From 2008 to 2011, period/spot/local/national advertising was down 20% in one year and up 20% the next without any of the studios anticipating the swings accurately o Current accounting within media/entertainment allows similar treatment (to the proposal) in film accounting and syndication licensing, which are viewed as problem areas by users Would prefer to move film/syndication accounting to current treatment for barter advertising, rather than the reverse Likely to create lumpy revenue recognition with an increasing disconnect between EBITDA and cash flow o Users believe the proposal will cause significant revenue revisions, which users dislike Users do not believe the proposed model more accurately reflects the economics of a television barter transaction o Users commented that they prefer revenue recognition to line up more closely to when the cash is received o Several users questioned how an estimate for a future spot price can be better than waiting to see what is actually monetized o The proposal will create a bigger disconnect between the income statement and cash flow statement o If a company believes the current value on the sale of its copyrighted material creates the greatest value for shareholders today, it should license the programming without barter In the near-term, the proposal will make comparing historical results more difficult Additional disclosures needed: o Assumptions behind the accruals for the management assumptions o Barter revenue as a percentage of total revenue o Companies should show ratings guarantees associated with their forecasts, discount rate used to derive present value and a separate line item for corrections of past forecasts Page 5 of 9
Minority View (roughly 20%)- prefer proposal The proposal could do a better job of linking advertising revenue booked in a period to delivery of impressions in a period, which one user believed was an improvement o User thinks that the proposed guidance more accurately reflects the economics of a barter transaction While current accounting causes barter revenues to be booked on a cash basis, in theory the accrual basis would enhance the predictive ability of cash flows Barter advertising is fairly small today, so the change will not have a significant impact Additional disclosures needed: o Barter revenue as a percentage of total revenue o Differences in the original fair value estimate and the cash received for the transaction. How spot market pricing changed between the time if the initial revenue recognition and the delivery of that inventory Page 6 of 9
Asset Managers Outreach Summary of outreach conducted They cover both traditional and alternative asset managers The staff discussed the following topics with the analysts: o The revenue constraint in the proposed model that would delay revenue recognition for performance based fees (carried interest) o Disclosures The majority of the analysts were in favor of recognizing revenue for performance based fees when the fees are realized and supported the ED s proposed change to the way alternative asset managers would recognize revenue o It is impossible to forecast net income when performance based fees are included o Delaying revenue recognition until performance based fees are realized is far from perfect, but it s conservative and better than including revenue that may reverse in future periods o Proposed change would result in improved comparability both within the alternative asset managers and with the traditional asset managers o Companies that recognize performance based fees using Method 2 under current U.S. GAAP (the mark to market method) told analysts to ignore it when market values dropped in 2008 o Companies complain about Method 2 when earnings are bad and have noted that it has limited usefulness due to its volatility One analyst stated it would not be good or bad to require all asset managers to recognize performance based fees when they are realized instead of on a mark to market basis o Regardless of what method the Board decides to include in the final standard, information is needed about both methods o He noted that the proposed model would eliminate the risk of unreliable fair value marks being included in net income The analysts stated that performance based compensation expense should be recognized on the same basis as performance based revenue o If performance based compensation expense is being recognized based on unrealized gains, this is contrary to what companies are telling analysts now Feedback on disclosures All of the analysts stated that disclosure of the amount of performance based fees that are realized versus unrealized is necessary o They cited Oaktree s rollforward of realized and unrealized performance based fees as a best practice example (Oaktree reports using Method 1) There should be disclosures about clawback provisions on incentive fees Page 7 of 9
Analysts need to see both the portfolio market values and the accrual for incentive based receivables o Incentive based receivables should be broken down to the fund level One analyst recommended a tabular disclosure of the following by fund: o capital committed o capital deployed o terms of performance fees (including hurdle rates) o investment proceeds realized to date o fair value of remaining portfolio investments at the balance sheet date o accrued carry (either on balance sheet or the amount that would be realized if all portfolio companies were sold at today s fair value) o potential clawback of performance fees/carry realized to date Page 8 of 9
Financial Services Outreach Summary of outreach conducted The staff asked users about the proposed changes to accounting for sales of real estate and provided an example of how the accounting would change when a bank sells real estate that it owns to a customer and provides significant financing to the customer A majority of the users support the proposed change to the accounting for sales of real estate for the following reasons: o The proposed model is simple when compared to current accounting o Sales of real estate are viewed as one time in nature, so recognizing a gain or loss when the customer obtains control of the property rather than over several periods will enable users to make better valuations (i.e. they back out the gain or loss anyway, so the proposed ED would enable them to back it out only once instead of over several periods) o It more accurately reflects the economics of the transaction Those who supported the proposed change to the accounting for sales of real estate had the following reservations: o There are some worries about banks recognizing a big gain while providing financing to a customer who may not be capable of fully repaying the loan, and how/when this will be reflected in bad debt expense o Will all transactions be at arm s length? o The following disclosures are necessary if this accounting change is made: The amount of seller financing and the loan to value ratio The interest rate charged on loans with seller financing The amount of loans with below market financing rates The amount of gains on sales of previously impaired properties Several users did not support the proposed change to the accounting for sales of real estate for the following reasons: o If risk has not transferred then the full amount of profit should not be recognized o The proposed change seems inconsistent with the Board s decisions on repo accounting o Net income will be inflated based on a transaction that is somewhat manufactured o Companies will be incentivized to use real estate sales as a profit center, to boost regulatory capital, and to mislead investors Page 9 of 9