AASB 15 Revenue from contracts with customers. Consumer and industrial markets 15 November 2016

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AASB 15 Revenue from contracts with customers Consumer and industrial markets 15 November 2016

Your facilitators for today are Kim Heng Kristen Haines Etienne Gouws Brandon Dalton 2

Agenda Introduction The 5 step model with practical examples Implementation considerations

Introduction

Where are we at? Applicable years beginning on or after 1 Jan 2018 1 Jan 2017 1 April 2017 1 July 2017 1 Oct 2017 31 Dec 2017 31 March 2018 30 June 2018 30 Sept 2018 31 Dec 2018 31 March 2019 30 June 2019 30 Sept 2019 Comparative period* First year * If a retrospective transition method applied Disclosures around standards issued but not yet effective 5

What does AASB 15 require? Core principle Recognise revenue to depict transfer of promised goods or services to customers in amount that reflects consideration to which entity expects to be entitled in exchange for those goods or service 1 5 2 4 Identify the contract(s) with a customer 3 Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to performance obligations in the contract Recognise revenue when (or as) the entity satisfies a performance obligation 6

The 5 step model with practical examples

Step 1: Identifying the contracts with customers 1... collection of consideration is considered probable.... rights to products or services and payment terms can be identified. A contract exists if...... it has commercial substance.... it is approved and the parties are committed to their obligations. 8

What is length of contracted term? 1 A contract only exists in the period it is enforceable Can customer leave at any time? Are there significant termination penalties? Contract term can impact: Performance obligations identified Determination of transaction price Period over which upfront fees/revenue can be recognised Period over which fulfilment costs can be amortised 9

Example 1 Contract term 1 Example: 1.1 Manufacturer A enters into 3 year MSA with customer C for sale of bottles C must purchase 1m bottles No upfront consideration Other than payment for 1m bottles, no further termination fees. 1.2 Manufacturer A enters into 3 year MSA with customer C for sale of bottles No minimum quantity to be purchased by C A pays C $200k on signing of MSA. $200k is not subject to clawback No termination fees C can only purchase these bottles from A and it is virtually certain that C will purchase at least 1m bottles from A. Contract? Contract exists for 1m bottles. Contract does not exist. Exclusivity or economic compulsion does not give rise to enforceable rights and obligations. Q: What is the accounting for the $200k payment? Watch this space! 10

Step 2: Identify performance obligations 2 A promise to transfer to customer a distinct good or service Capable of being distinct Can customer benefit from promise on its own or together with other resources that are readily available? + Distinct within the context of the contract Is it separately identifiable from other promises in the contract? 11

Distinct within the context of the contract 2 1 2 3 Are we providing a significant service of integration? Are we customising or modifying the goods significantly? Is the good or service highly dependent on or highly interrelated with other goods or services in the contract? If the answer is yes to any of these questions, not separately identifiable 12

Example 2: Identifying performance obligations 2 Company A enters into a contract with Customer B to sell a piece of equipment. Promises in the contract include: Equipment Free installation/integration 1-year standard warranty 2-year extended warranty Discount of 20% on 10,000 units of consumables Only A can perform installation. Installation does not significantly modify or customise equipment. 13

Example 2 solution: Identifying performance obligations 2 What has Company A promised in the contract? Criteria Equipment Installing equipment 1 year standard warranty 2-year extended warranty Capable of being distinct Yes Yes No Yes Separately identifiable Yes Yes N/A Yes Separate PO? Yes Yes No Yes Q: What about the discount on consumables? 14

Example 2 solution: Identifying performance obligations 2 Entity grants customer option to acquire additional goods or services Could customer obtain right to acquire additional goods or services without entering into sales agreement? No Yes Option give customer right to acquire additional goods or services at price that reflects stand-alone selling price for goods or services? No Yes Option is material right that gives rise to performance obligation Option does not give rise to performance obligation Allocated consideration will be recognised when goods or services are transferred or option expires 15

Example 2 solution: Identifying performance obligations 2 There are 4 performance obligations Promises in the contract Supply of equipment Free installation/integration 1-year standard warranty 2-year extended warranty Customer option Performance obligation? (combined with equipment) 16

Example 3: Performance obligations and tooling 2 Contract manufacturer T enters into a 6-year MSA with Customer C to manufacture bottle X. MSA does not include contractually committed volumes. Shape of bottle X is covered by customer specific intellectual property. On signing of the MSA, T arranges for and funds manufacture of customer specific tooling. MSA stipulates any customer specific tooling can only be used to manufacture C s product. At end of manufacturing arrangement, customer specific tooling will be provided to C. MSA includes clause that if MSA is terminated by C before specified target volumes are achieved, T will be entitled to a payment based on a fixed schedule with compensation reduced over-time as quantities are purchased. Tooling is operated and maintained by T. Q1: Is MSA a contract for tooling? Q2: Does control of the tooling transfer to the customer? Q3: Is tooling a distinct performance obligation? 17

Example 3 solution: Performance obligations and tooling 2 Step 1: Identify the contract(s) with a customer MSA requires that if agreement is terminated by C, T will be entitled to payment for tooling sufficient to cover cost of manufacture plus a profit margin. MSA includes enforceable rights and obligations in respect of tool. Step 2: Identify the performance obligations in the contract Q2: Does control of tooling transfer to customer? Q3: Is tooling a distinct performance obligation? 18

Example 3 solution: Performance obligations and tooling 2 Q2: Does control of the tooling transfer to the customer? Factors to consider Assessment Customer can direct use and prevent others from using the tool Tooling can only be used to manufacture bottle X for C Economic benefits from tool depend entirely on orders from customer Substantive transfer of legal title if it is technically and economically feasible for another manufacturer to use tool MSA does not contain minimum purchase quantity, dependent on C issuing purchase orders Practically tooling cannot be used by another manufacturer Consideration for tooling exists In event of termination or insufficient quantities are purchased Tool is operated and maintained by manufacturer Tooling is operated and maintained by T Judgement required. A conclusion of no control transferring for tooling means no need to assess if tooling is a distinct performance obligation. Account for tooling as PP&E or intangible assets if criteria met. Otherwise, assess for capitalisation as fulfilment costs. BUT if control does transfer. 19

Example 3 solution: Performance obligations and tooling 2 Q3: Is the tooling a distinct performance obligation Factors to consider Assessment Is development of tool interrelated or integrated with production of bottles? No development of tool is not interrelated/integrated with production of bottle. Tooling is specialised, but remainder of production process is same as for other customers. No transformative relationship between bottle and tool. Must customer buy tooling together with the bottles? No No minimum purchase requirement. C can choose to buy or not buy bottles, this does not affect purchase of tool. C required to pay T for cost of tool if no bottles purchased. Tooling likely to be a distinct performance obligation. 20

Example 4: Tolling arrangements 2 Company A sells and distributes mobile phones. Company B s principal activity is provision of assembling services. A determines specification and design of phone and B is not responsible for any design flaws or defects in raw materials used in manufacture of phones. B sells finished phones at cost + margin to A. B negotiates its margin/pricing with A based on it s value added services arising from labour, overheads, depreciation of machineries, etc. B does not earn a margin on raw materials. All raw materials must be purchased from A, B purchases raw materials based on forecast orders submitted by A. B is not exposed to any change in pricing of raw materials or any foreign exchange fluctuations. There is no restriction on quantity of raw materials that B can purchase from A nor on their use for B s other customers. 21

Example 4 solution: Tolling arrangements 2 Considerations What is the promise to A? B solely provides assembly services based on instructions of A. B is not selling A finished phones. B does not suffer from price fluctuation and only orders raw materials based on orders by A. B has no involvement in mobile phone design specifications. Revenue likely to be recognised net of the raw material costs. 22

Step 3: Determine the transaction price 3 Variable consideration Non-cash consideration Transaction price Significant financing component Consideration payable to customer 23

Variable consideration 3 Variable consideration can be: Discounts Credits Incentives Performance bonuses Many more... Variable consideration is estimated using most appropriate method of either: Expected Value (Sum of probability-weighted amounts in a range of possible outcomes) Most Likely Amount (Single most likely outcome, when the transaction amount has a limited number of possible outcomes) Capped at an amount for which it is highly probable that a significant reversal will not occur. 24

Example 5: Volume rebates retrospective 3 Entity X has a two-year contract with Customer Y to supply beer. Contract price of beer is $1 per litre with a rebate allowance specified in contract dependent on total sales volume over two-year period. Rebate is paid at end of year 2 and applied retrospectively as follows: $0.01 per litre for up to 50,000 litres $0.03 per litre for > 50,000 litres $0.05 per litre for >100,000 litres At contract inception, X expects Y will make the following purchases with following probabilities: 5% probability of 55,000 litres 35% probability of 75,000 litres 55% probability of 100,00 litres 5% probability of 120,000 litres In year 1, Y buys 60,000 litres. Q: How would X estimate transaction price at contract inception and at end of year 1? 25

Example 5 solution: Volume rebates retrospective 3 X would use Expected Value method to estimate sales during two-year period. Estimated litres Probability Weighting 55,000 litres 5% 2,750 75,000 litres 35% 26,250 100,000 litres 55% 55,000 120,000 litres 5% 6,000 Expected Value 90,000 X would use also consider constraint and not underestimate quantity that will be sold. Based on 5% probability Y will purchase quantities in excess of 100,000 litres, entitling Y to a discount larger than $0.03, at contract inception 90,000 litres is used to estimate the variable consideration taking into account constraint. 26

Example 5 solution: Volume rebates retrospective 3 At contract inception, X estimated 90,000 litres of sales to Y. Litres Price per Litre Total expected consideration Litres 1 100,000 90,000 $0.97 $87,300 However, based on sales to end of year 1, X revises its expected value to 120,000 litres. How much revenue would X recognise at end of year 1 on 60,000 litres of sales? Litres Price per Litre Total revenue Litres 1 100,000 60,000 $0.97 $58,200 True-up adjustment ($0.05-$0.03*60,000) $(1,200) Year 1 revenue $57,000 27

Example 6: Volume rebates prospective 3 Same fact pattern as per Example 5, however, rebate is applied prospectively as follows: Nil per litre for up to 50,000 litres $0.03 per litre for 50,001 100,000 litres $0.05 per litre for 100,000+ litres Q: Would accounting change if rebate was applied prospectively? If yes, how? 28

Example 6 solution: Volume rebates prospective 3 Prospective volume rebate is a material right representing a discount on future purchases. Estimate standalone selling price consider level of discount and probability material right will be exercised (i.e. probability volume rebate will be achieved). Allocate transaction price between underlying good or service (e.g. beer) and material right. Recognise when underlying goods or services are purchased using option or when option expires. I.e. only true-up for downward change in estimate of volume once discount period expires end of two years. Currently unclear on what to do with upward change in estimate of volume. Watch this space! 29

Other typical types of rebates, discounts, etc. 3 Examples Change in price due to change in cost Time-based rebates E.g. 3-year supply contract where pricing is as follows: Yr 1 - $1 per unit Yr 2 - $0.95 per unit Yr 3 - $0.90 per unit Considerations Future change in price (e.g. price for next 3 months depends on raw material average cost for immediately preceding 3 months) is not variable consideration. Retrospective change in price would likely be considered variable consideration. No minimum quantities, then this is not variable consideration. Minimum purchase quantities likely to be considered variable consideration. 30

Step 4: Allocating consideration to performance obligations 4 Allocate based on relative stand-alone selling prices Performance obligation 1 Performance obligation 2 Performance obligation 3 Determine stand-alone selling prices Observable price Estimate price Fair value measurement Adjusted market assessment approach Expected cost plus a margin approach Residual approach only if selling price is highly variable or uncertain 31

Example 7: Allocating consideration 4 Same as example 2. Company A enters into a contract with Customer B to sell a piece of equipment for $500k. 4 performance obligations identified in contract include: Equipment Free installation/integration 2-year extended warranty Discount of 20% on 10,000 units of consumables. Each consumable has stand-alone selling price of $10 and A expects 9,000 units purchased. A would sell equipment alone for $450k, installation alone for $90k and warranty at $30k a year. Q: How is consideration allocated to each performance obligation? 32

Example 7 solution: Allocating consideration 4 Performance obligation Stand-alone selling price % Transaction price allocation Contractually stated amount Equipment $450k 73% $365k Installation/Integration $90k 15% $75k 2-year extended warranty $60k 10% $50k $500k Discount on consumables $18k 2% $10k Total $618k 100% $500k $500k Allocation could result in revenue amounts different to invoiced amounts! 33

Example 8: Loyalty programs 4 Retailer C offers customer a loyalty program whereby for every $10 spent, 1 point is rewarded Each point is redeemable for a cash discount of $1 on future purchases C expects 97% of points to be redeemed (based on historical experience) During year 1, customers purchase $100,000 of product and earns 10,000 points Q: How is price allocated between the performance obligations? 34

Example 8 solution: Loyalty programs 4 Performance obligation Stand-alone selling price % Transaction price allocation Products $100,000 91% $91,000 Points $9,700 9% $9,000 Total $109,700k 100% $100,000 35

Step 5: Recognising revenue over-time 5 A performance obligation is satisfied over-time if: 1 Customer simultaneously receives and 2 The customer controls the asset as the entity 3 consumes the OR creates or benefits as the enhances it. OR entity performs. Routine or recurring services, e.g. maintenance services Asset built on customer s site, e.g. power plant on customer s land The entity s performance does not create an asset for which the entity has an alternate use and there is a right to payment for performance to date. Asset built to order 36

Recognising revenue at a point-in-time 5 Indicators that control has passed include a customer having a present obligation to pay physical possession legal title risks and rewards of ownership accepted the asset 37

Example 9: Over-time or point-in-time 5 Manufacturer T has a 5 year MSA with Customer X to manufacture a customer specific part for use in X s products. This part has no alternative use for T. Under MSA, X is not required to purchase a minimum quantity of parts. If X wishes to purchase parts, it must submit a purchase order. If X cancels purchase order for convenience, then it must pay T for any work in progress and any finished goods manufactured by T at the time of cancellation, at price current at time of cancellation. Please complete polling question 5 that will appear on your screen shortly 38

Example 9 solution: Over-time or point-in-time 5 Criteria for recognising revenue over-time Customer simultaneously receives and consumes benefit as entity performs; or Met? Customer controls asset as entity creates or enhances it; or Entity s performance (a) does not create an asset with alternative use, and (b) right to payment for performance to date Revenue on parts recognised over-time as parts are manufactured. Q: What about if MSA requires T to hold a certain quantity of safety stock, which X will pay for if contract is terminated for convenience? Watch this space! 39

Other potential issues Issue Combining contracts Freight Contract modifications Scrap sales Discussion Contracts are combined where: - Entered at or near same time with same customers or related parties of customer; and - Negotiated as a single commercial package, or - Consideration in contract is dependent on consideration in other contract, or - Goods or services (or some of goods or services) are a single performance obligation Delivery terms could impact identification of performance obligations. FOB freight is likely included with product as one performance obligations CIF freight and product could be considered two separate performance obligations Change in scope or price of a contract, or both. 3 possible accounting outcomes: - Cumulative catch-up adjustment - Account for as separate contract (prospective) - Account for as termination of existing contract and creation of new contract (prospective) Consideration of whether proceeds from the sale of scrap and by-products are revenue from contracts with customers. 40

Implementation considerations

Broader impacts Financial and operational system changes Existing systems may not capture required data Inventory of incremental information Processes re-designed Update systems vs new systems Dual systems for certain transition options Processing changes to contracts Governance and change Impact on internal resources Revenue change management team Change to contract practices Training (accounting, sales, etc) Multi-national locations Effect on management compensation metrics Impact on forecasting and budgeting processes Revenue Recognition Internal control assessment Effect on internal control environment New controls vs modify existing controls Identify new risk points Management review controls IT controls Process level controls Communication with stakeholders Key to successful implementation Identify relevant stakeholders Messaging Timing of communication Comparability of data communicated Expected impact of change 42

Implementation requires time 2016 2017 2018 Accounting and Reporting Contract analysis Accounting guidelines Preparation of the transition Systems and processes Analysis of processes/it Solution development Roll-out of new solutions People and change Training concept Performance of trainings Business Business model Sales concepts Stakeholder and capital markets communication Analysis Design Implementation Stabilisation 43

Next steps Assessing the impact to your organisation is a critical first step. The following activities may help position you to plan an effective implementation: 1 Establish project team and governance 2 Determine impacts to your accounting policies and disclosures 3 Identify new information requirements 4 Identify system and process gaps 5 Consider impact to internal controls 6 Involve tax resources 44

Next steps 7 Identify other parties that need to be involved 8 Develop initial thoughts regarding transition approach 9 Build a project plan 10 Determine the resource needs 11 Communicate with stakeholders and those charged with governance 12 Involve your external auditor throughout the process 45

What questions do you have?

KPMG resources available 47

Thank you Contacts Kim Heng Partner Tel: +61 2 9455 9120 kheng@kpmg.com.au Etienne Gouws Director Tel: +61 3 9838 4221 egouws1@kpmg.com.au Kristen Haines Senior Manager Tel +61 3 9288 5184 khaines@kpmg.com.au Brandon Dalton Manager Tel +61 2 9455 9313 bdalton1@kpmg.com.au

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