Issues & Trends Issues In-Depth January 2012, No. 12-1 Contents The Model 3 Step 1 Identify the Contract with a Customer 4 Step 2 Identify the Separate Performance Obligations in the Contract 8 Step 3 Determine the Transaction Price 19 Step 4 Allocate the Transaction Price to the Separate Performance Obligations 28 Step 5 Recognize Revenue When (or as) the Vendor Satisfies a Performance Obligation 34 Contract Modifications 47 Boards Revise Joint Revenue Recognition Exposure Draft The FASB and IASB (the Boards) recently issued a revised joint exposure draft on revenue recognition (2011 ED). 1 The Boards received nearly 1,000 comment letters on the original joint exposure draft (2010 ED) and after extensive deliberations revised parts of the proposed standard in response to many of the comments and other input received. 2 The revisions reflected in the 2011 ED eliminate or modify some of the provisions in the 2010 ED that would have created changes in practice from current U.S. GAAP. Nonetheless, significant differences still exist. If the 2011 ED is finalized in its current form, transaction- or industry-specific accounting guidance generally would be eliminated from U.S. GAAP, which would affect the accounting for certain long-term contracts, software arrangements, telecommunications, real estate, and other industries. The proposed standard also would affect how a vendor incorporates collectibility into recognition and presentation of revenue, would require more estimates than in current practice, would require more detailed disclosures primarily for public companies in both interim and annual periods, including rollforward of certain information, and could change the accounting for certain contract acquisition and fulfillment costs. Contract Costs 50 Onerous Performance Obligations 54 Specific Application Issues 56 Sale of Assets That Are Not Part of a Vendor s Ordinary Activities 67 Presentation and Disclosures 69 Effective Date and Transition 73 Other Observations 74 Summary of Significant Recognition and Measurement Comparison between the 2011 Exposure Draft and Current U.S. GAAP 76 1 FASB Proposed Accounting Standards Update (Revised), Revenue from Contracts with Customers, November 14, 2011, available at www.fasb.org, and IASB ED/2011/6, Revenue from Contracts with Customers, November 2011, available at www.ifrs.org. 2 FASB Proposed Accounting Standards Update, Revenue from Contracts with Customers, June 24, 2010, available at www.fasb.org, and IASB ED/2010/6, Revenue from Contracts with Customers, June 2010, available at www.ifrs.org. 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a
The Boards decided to re-expose the proposed standard because revenue recognition affects virtually all business entities and they wanted to identify potential unintended consequences from applying the proposed standard before it is finalized. They are seeking input on whether the proposed standard is clear and can be applied in a way that effectively communicates to financial statement users the economic substance of the vendor s contracts with customers. The Boards have specifically requested comments on the following items in the 2011 ED: Recognition of revenue as a vendor transfers control of a good or service over time; Accounting for the effects of customer credit risk; Cumulative constraint on revenue when consideration is variable; Scope of the onerous performance obligation test; Disclosure requirements for interim financial statements; and Accounting for the transfer of nonfinancial assets that are not an output of the vendor s ordinary activities. In connection with the 2011 ED, the FASB recently issued an exposure draft of the proposed consequential amendments to the FASB Accounting Standards Codification (the proposed Codification amendments). 3 Comments on the 2011 ED and the proposed Codification amendments are due by March 13, 2012, and the Boards hope to issue a final standard in the second half of 2012. The FASB requests interested parties to submit one set of comments on both the 2011 ED and the proposed Codification amendments. 4 The observations, examples, and potential changes to current practice discussed in this publication are based on our current understanding and interpretation of the proposed standard. 5 The assessment of the potential effect and conclusions are subject to further interpretation once the final standard is issued. The 2011 ED would apply to all contracts with customers except for: Lease contracts; Insurance contracts; Contractual rights or obligations within the scope of certain financial instruments guidance; 6 Guarantees (other than product or service warranties); and 3 FASB Proposed Accounting Standards Update, Revenue from Contracts with Customers Proposed Amendments to the FASB Accounting Standards Codification, January 4, 2012, available at www.fasb.org. 4 FASB Proposed Accounting Standards Update (Revised), Revenue from Contracts with Customers (including Proposed Amendments to the FASB Accounting Standards Codification), November 14, 2011 and January 4, 2012, available at www.fasb.org. 5 While the proposed standard would converge U.S. GAAP and IFRS, this publication focuses on the potential changes to U.S. GAAP. 6 FASB ASC Topics 310, Receivables; 320, Investments Debt and Equity Securities; 405, Liabilities; 470, Debt; 815, Derivatives and Hedging; 825, Financial Instruments; and 860, Transfers and Servicing; all available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 2 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
Nonmonetary exchanges between vendors in the same line of business to facilitate sales to customers other than the parties to the exchange. 7 While some clarifications were made, the scope is largely unchanged from the 2010 ED. Observations Current U.S. GAAP requirements relating to the recognition of regulatory assets and liabilities from alternative revenue programs are not within the scope of the proposed standard. 8 However, the proposed standard does require revenue arising from regulatory assets and liabilities to be presented separately from revenues arising from contracts with customers in the statement of comprehensive income. Entities would continue following current U.S.GAAP requirements to account for such programs because the Boards believe that those contracts are considered to be contracts with a regulator and not with a customer, which may result in a difference for rate-regulated entities with similar alternative revenue programs that follow the IASB s proposed standard. A contract with a customer may be partially in the scope of the 2011 ED and partially in the scope of other accounting guidance (e.g., a contract with a lease of an asset and services). If the other accounting guidance specifies how to separate and/or initially measure one or more parts of a contract, then a vendor would first apply those requirements. Otherwise, the vendor would apply the 2011 ED to separate and/or initially measure the separately identified parts of the contract. This guidance is consistent with the current guidance on multiple-element arrangements that address the interaction with other guidance. 9 The Model The core principle of the revenue recognition model is that a vendor should recognize as revenue the amount that reflects the consideration to which the vendor expects to be entitled in exchange for goods or services when (or as) it transfers control to the customer. To achieve that core principle, the 2011 ED establishes a five-step model that a vendor would apply: (1) Identify the contract with a 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; and (5) Recognize revenue when (or as) the vendor satisfies a performance obligation. 7 See the Purchases and Sales of Inventory with the Same Counterparty subsections of FASB ASC Subtopic 845-10, Nonmonetary Transactions Overall, available at www.fasb.org. 8 FASB ASC Section 980-605-25, Regulated Industries Revenue Recognition Alternative Revenue Program (formerly EITF 92-7, Accounting by Rate-Regulated Utilities for the Effects of Certain Alternative Revenue Programs), available at www.fasb.org. 9 FASB ASC paragraph 605-25-15-3A, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 3 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
Step 1 Identify the Contract with a Customer The 2011 ED defines a contract as an agreement between two or more parties that creates enforceable rights and obligations and specifies that enforceability is a matter of law. The proposed standard states that an enforceable contract can be written, verbal, or implied by the vendor s customary business practices as long as it is enforceable under law in the applicable jurisdiction. A customer is defined as a party that has contracted with a vendor to obtain goods or services that are an output of the vendor s ordinary activities. Other parties to a contract may not be customers, but may be partners or collaborators with the vendor in developing goods or services to be sold to customers. In this situation, the guidance in the proposed standard would not apply. A contract with a customer would be within the scope of the proposed standard only if all of the following criteria are met: The contract has commercial substance, meaning the contract is expected to alter the risk, timing, or amount of the vendor s future cash flows; The contract is approved by all parties and they are committed to fulfill their obligations; The vendor can identify each party s rights for the goods or services to be transferred; and The vendor can identify the payment terms for those goods or services. Notwithstanding the above criteria, a contract would not exist under the proposed standard if each party has the unilateral right to terminate a wholly unperformed contract without compensation. Observations Because the proposed standard defines a contract as an agreement that creates enforceable rights and obligations, the contract terms have a significant effect on whether enforceable rights and obligations exist and when and how a vendor recognizes revenue. Therefore, it would be important to understand the contract terms to be able to assess the potential implications of applying the proposed standard. As described in the section, Step 2 -- Identify the Separate Performance Obligations in the Contract, while the contract must create enforceable rights and obligations, not all of the performance obligations need to be legally enforceable to meet the distinct criterion and be treated as a separate unit of account within the contract. Under current guidance, the SEC believes that revenue generally is earned and realizable when four criteria are met, one of which is that persuasive evidence of an arrangement exists. 10 While the proposed standard s definition of a contract may be consistent with persuasive evidence of an arrangement, there may be instances where differences could arise. For example, under current guidance, if a vendor receives a purchase order from a customer and the goods are shipped to the customer free on board (FOB) shipping point before year-end, the vendor does not recognize revenue until a written sales agreement is finalized with the customer if that is the vendor s customary business practice. Under the proposed standard, assuming control of the goods has been 10 SEC Staff Accounting Bulletin Topic 13, Revenue Recognition, available at www.sec.gov. Issues In-Depth / January 2012 / No. 12-1 4 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
transferred to the customer, if the placement of the customer order and shipment of the product constitute an enforceable legal contract, revenue would be recognized at the time of shipment. Similar arrangements in multiple jurisdictions may be treated differently if the definition of enforceable legal contract varies. Some respondents to the 2010 ED noted that for oral and implied contracts it may be difficult to meet the criteria that the parties to the contract have approved the contract. The Boards decided that the form of the contract does not, in and of itself, determine whether the parties have approved and are committed to the contract. A vendor should consider all relevant facts and circumstances in assessing whether an enforceable contract exists. In cases of significant uncertainty about enforceability, the Boards acknowledge that a written contract may be required to determine that the parties to the contract have approved and are committed to perform under the contract. Collaborative Arrangements. The Boards have explicitly excluded from the scope of the proposed standard contracts with a collaborator or a partner that are not customers but rather merely share with the vendor the risks and benefits of developing a product to be marketed. Therefore, it will be important for a vendor that engages in collaborative arrangements to analyze whether the other parties to such arrangements are customers (i.e., a party that has contracted with the vendor to obtain goods or services that are an output of the vendors ordinary activities) and, thus, lead to revenue generating activities, or not. For example, a biotech entity may conclude that a collaborative arrangement with a pharmaceutical entity to provide a license to a drug candidate and ongoing research and development includes a revenue contract that is in the scope of the proposed standard because the pharmaceutical entity is a customer that receives the license and services as part of the biotech entity s ordinary activities. Current accounting guidance provides income statement presentation guidance with respect to collaborative arrangements, which is defined as an arrangement that meets the following two criteria: (a) the parties are active participants in the arrangement and (b) the participants are exposed to significant risks and rewards that depend on the endeavor's ultimate commercial success. 11 It is our understanding that this guidance would not be superseded by the proposed standard. However, current U.S. GAAP requirements do not provide recognition and measurement guidance for collaborative arrangements. Because the Boards have explicitly excluded collaborative arrangements with parties that are not customers from the scope of the proposed standard, we generally believe that a vendor would continue to account for those arrangements based on its current accounting policy. Gas-Balancing Arrangements. The Boards note in the Basis for Conclusions that arrangements in the oil and gas industry in which partners in an offshore oil and gas field may make payments to each other to settle any differences between their proportionate entitlements to production volumes from the field during a reporting period may not be contracts with a customer. Therefore, a vendor would need to assess whether those arrangements are within the scope of the proposed 11 FASB ASC Subtopic 808-10, Collaborative Arrangements Overall, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 5 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
standard. Under current U.S. GAAP practice for a natural gas arrangement, a vendor may present the participants share of net revenue as revenue regardless of which partner has actually made the sale and invoiced the production (commonly known as the entitlement method). It appears that the proposed standard would not be consistent with current SEC staff guidance relating to the entitlement method of accounting for gas-balancing arrangements. 12 Under the proposed standard, the gas-balancing arrangement may be considered to comprise (a) the actual sale of product to a third party, which would be accounted for as revenue from a contract with a customer, and (b) accounting for imbalances between the partners, which would be accounted for outside the scope of the proposed standard. Combining Contracts. The 2011 ED proposes criteria for determining when a vendor would be required to combine two or more contracts and account for them as a single contract. Contracts entered into at or near the same time with the same customer (or related parties) would be combined if one or more of the following criteria are met: The contracts are negotiated as a package with a single commercial objective; The amount of consideration in one contract is dependent on the other contract; or The goods or services in the contracts are a single performance obligation (see Step 2 Identify the Separate Performance Obligations in the Contract). The Boards eliminated a proposal in the 2010 ED that would have required a vendor to segment a single contract and account for it as two or more contracts if certain criteria were met. That provision was intended to allow a discount or variable consideration to be allocated to specific performance obligations in certain situations. Board members concluded that segmenting would be redundant to identifying separate performance obligations within a contract. However, the notion of allocating a discount or variable consideration within a contract to some, but not all performance obligations, in certain situations has been retained in Step 4 of the revised model, which usually would result in a similar outcome to the proposal under the 2010 ED to segment the contract. Observations Current U.S. GAAP on multiple-element arrangements contains a rebuttable presumption that contracts entered into at or near the same time with the same entity or related parties are a single contract. Existing software guidance provides a list of six indicators a vendor considers to determine whether multiple contracts with the same customer should be combined and accounted for as a single multiple-element arrangement. While one of the indicators is that the contracts are negotiated or executed within a short time frame of each other, it is only an indicator to be considered along with the other five indicators. Under the proposed standard, vendors would be required to combine 12 FASB ASC paragraph 932-10-S99-5, Extractive Activities Oil and Gas Overall-SEC Material-SEC Staff Guidance Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings - SEC Observer Comment Accounting for Gas-Balancing Arrangements, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 6 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
contracts if the contracts are entered into at or near the same time with the same customer (or related parties) and any one of the three specified criteria is met. While similar in concept to current guidance, this may result in more situations where multiple contracts would be combined under the proposed standard compared to existing requirements because there would be specified criteria instead of indicators to consider. Related Parties. The proposed standard specifies that for two or more contracts to be combined, they should be with the same customer (or related parties). The Basis for Conclusions notes that the term related parties as used in the proposed standard has the same meaning as the definition in current related party guidance. 13 Customer under the Contract. When applying the guidance on combining contracts, the vendor would need to determine who the customer is under the contract to apply the contract combination guidance. Based on Step 1 -- Identify the Contract with a Customer, contracts entered into by the vendor with various parties in the distribution channel that are not customers of the vendor are not combined. Typically for automotive manufacturers, the customer for the sale of the vehicle is the dealer while the customer for an operating lease agreement that finances the car is the end user. Because the dealer and the end-user are not related parties, those contracts (the initial sales contract for the vehicle to the dealer and the subsequent lease contract with the end user) would not be evaluated for combining purposes and would be treated as separate contracts. However, for purposes of consideration payable to a customer under Step 3 Determine the Transaction Price, a vendor would consider other parties in the distribution chain that purchase the vendor s goods or services from the vendor s customer, regardless of whether the purchaser receiving the consideration is a direct customer of the vendor. Practical Expedient. In most cases, vendors would apply the proposed guidance to individual contracts with a customer. However, in some situations, as a practical expedient, a vendor may combine multiple contracts for purposes of revenue recognition. For example, the proposed standard specifies that a vendor can account for a portfolio of similar contracts (or performance obligations) together if the vendor expects that the result will not be materially different from the result of applying the proposed standard to the individual contracts (or performance obligations). Example 1: Combining Contracts Company A enters into a contract to license its customer relationship management software to Customer B. Three days later, in a separate contract, Customer A agrees to provide consulting services to significantly customize the licensed software to function in Customer B s IT environment. Customer B is unable to use the software in its IT environment until the customization services are complete. Company A determines that the two contracts would be combined because: 13 FASB ASC Topic 850, Related Party Disclosures, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 7 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
The contracts were entered into near the same time with the same customer, and The goods and services in the contracts are a single performance obligation because the vendor is providing a significant service of integrating the license and consulting services into the combined item for which the customer has contracted. Company A also must provide a significant integration service to customize the software to fulfill the contract. Step 2 Identify the Separate Performance Obligations in the Contract The 2011 ED defines a performance obligation as a promise in a contract with a customer to transfer a good or service to the customer. In the 2011 ED, the Boards removed the word enforceable from the definition of a performance obligation and clarified that performance obligations include promises that are implied by a vendor s customary business practices, published policies, or specific statements if those promises create a valid expectation by the customer that the vendor will transfer goods or services. A single contract may have promises to deliver more than one good or service. A vendor would need to evaluate the promised goods or services to determine whether each good or service (or a bundle of goods or services) constitutes a separate performance obligation. The 2011 ED would require a vendor to use judgment and consider all facts and circumstances when making this evaluation. A vendor would account for a promised good or service as a separate performance obligation only if it is distinct from other goods or services in the contract. A promised good or service would be distinct if: (a) The vendor regularly sells the good or service separately, or (b) The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. Readily available resources are goods or services that are sold separately by the vendor or by another vendor, or resources that the customer already has obtained from the vendor or from other transactions or events. When evaluating criterion (b), the order of delivery of goods or services could determine whether a good or service is a separate performance obligation. For example, a company enters into an arrangement to transfer two products that are never sold separately to its customer. Product A can be used on its own, but Product B cannot be used without Product A. If Product A is delivered first, the products would be separate performance obligations. However, if Product B is delivered first, it would not be considered distinct and would be combined with Product A into a single performance obligation. Notwithstanding the distinct criteria above, goods or services in a bundle of promised goods or services should be accounted for as a single performance obligation, if: (1) The promised goods or services are highly interrelated and transferring them to the customer requires the vendor to provide a significant service of integrating the goods or services into the combined item for which the customer has contracted; and Issues In-Depth / January 2012 / No. 12-1 8 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
(2) The bundle of goods or services is significantly modified or customized to fulfill the contract. This guidance was provided to address preparers concerns about accounting for long-term construction contracts with multiple phases that may overlap or may be highly interrelated. Many tasks and activities in a long-term contract that otherwise may be distinct may be combined into a single performance obligation as a result of this guidance. That could result in the vendor accounting for all the promised goods or services in a contract as a single performance obligation. The 2011 ED also would allow entities, as a practical expedient, to account for two or more distinct promised goods or services as a single performance obligation if those promised goods or services have the same pattern of transfer to the customer. Observations Distinct versus Standalone Value. The proposed standard s separation requirement for goods or services to be distinct in order to be accounted for separately is similar, but not identical, to the standalone value criterion required under the current guidance on multiple-element revenue arrangements. 14 Specifically, a delivered item has value on a standalone basis if it is sold separately by any vendor or the customer could resell the delivered item on a standalone basis. Under the proposed standard, to determine whether a good or service is distinct, a vendor would consider whether the vendor sells the good or service separately and no longer would consider whether another vendor sells an identical or largely interchangeable good or service separately. Additionally, a vendor no longer would explicitly consider whether the delivered item could be resold by the customer to support a conclusion that a good or service is distinct. However, the Boards note in the Basis for Conclusions that the concept of distinct would encompass a situation in which the customer could benefit from the asset on its own if the customer has the ability to resell the asset and recover a substantial portion of the selling price. Bundles of Goods or Services. The proposed requirement that a vendor account for a bundle of promised goods or services that otherwise might be distinct as a single performance obligation if certain criteria are met (i.e., highly interrelated requiring a significant integration service and the bundle is significantly modified or customized to fulfill the contract) was provided to address concerns raised by many constituents with longterm construction or production-type contracts. Those constituents highlighted that in many construction contracts, a contractor provides an integration service to manage and coordinate various construction tasks such as using goods or services as inputs into a single process or project that is the output of the contract. To address those concerns the Boards added the first criterion that the promised goods or services are highly interrelated and to transfer them requires the vendor to provide a significant service of integrating the goods or services into the combined item for which the customer has contracted. In addition, the Boards added the second criterion that the bundle of goods or services is significantly modified or customized to fulfill the contract because without it, there would be risk that all contracts that include any type of integration service might be deemed to be a single performance 14 FASB ASC paragraph 605-25-25-5, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 9 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
obligation even if the integration risk that the vendor assumes is insignificant (e.g., the sale of equipment with a simple installation). As a result of the revised guidance, many tasks and activities in a longterm contract that otherwise may be distinct would be combined into a single performance obligation. While these criteria were developed primarily in response to the construction industry, the criteria would apply to other transactions and industries as well. For example, certain software development contracts may meet the criteria to be accounted for as a single performance obligation. Vendors in industries that bundle goods with significant services should consider whether the criteria for combining goods and services into a single performance obligation are met. In making that determination, a vendor would need to consider all facts and circumstances and apply judgment for each contract to determine whether a bundle of goods or services in a contract is a single performance obligation. Income Statement Presentation. Although the proposed standard would allow a vendor to account for two or more distinct goods or services as a single performance obligation if they have the same pattern of transfer, the current SEC regulations require that product and service revenues be displayed separately on the income statement if certain quantitative thresholds are met. 15 If these SEC requirements remain, SEC registrants will still need to apply a systematic and rational approach to allocating the revenue between products and services when using the practical expedient. Administrative Task. Some respondents to the 2010 ED suggested that the proposed standard should exempt certain performance obligations that are considered to be inconsequential or perfunctory, similar to current SEC guidance. In addition, some suggested that certain goods or services should be accounted for as marketing expenses. The Boards decided that the proposed standard should not exempt entities from accounting for performance obligations that are inconsequential or perfunctory unless they are assessed as immaterial based on current U.S. GAAP. 16 Likewise, they decided that all goods or services that are promised in a contract with a customer are performance obligations regardless of whether the vendor considers some goods or services to be marketing incentives. However, the Boards noted in the proposed standard that certain activities that a vendor must undertake to fulfill a contract are not performance obligations because those activities do not transfer goods or services to the customer. For example, a service provider may need to perform various administrative tasks to set up a contract. Because those setup activities do not transfer a good or service to the customer, they are not performance obligations. It is not clear whether the Boards intent with the guidance on administrative tasks is to reiterate that activities that do not transfer goods or services are not distinct and, thus, not separate performance obligations, or to highlight that certain fulfillment activities themselves are not performance obligations and would not impact revenue recognition. For example, if a vendor is required to deliver a good to a 15 SEC Regulation S-X, Rule 5-03(b), available at www.sec.gov. 16 FASB ASC Topic 105, Generally Accepted Accounting Principles, available at www.fasb.org; and SEC Staff Accounting Bulletin Topics 1M, Materiality, and 1N, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, both available at www.sec.gov. Issues In-Depth / January 2012 / No. 12-1 10 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
customer and also physically deliver the product manual to the customer, would the requirement to deliver the product manual be a separate performance obligation or simply an administrative task? If considered only an administrative task, would all the revenue under the contract be recognized upon transfer of the product even if the product manual has not been delivered? To further illustrate, under the current codification topic for software revenue recognition, a requirement by a software vendor to provide additional copies of software to a customer would not preclude the vendor from recognizing all the revenue upon delivery of the first copy or product master if all of the other revenue recognition criteria have been met. Instead, the estimated duplication costs would be accrued at the time that revenue is recognized. Under the proposed standard, it is not clear whether the vendor s obligation to deliver each additional copy would be considered an administrative task and not a separate performance obligation or whether each additional copy would be considered a separate performance obligation. Example 2: Construction (Based on Example 5 in the 2011 ED) Construction Co. enters into a contract to design and build a hospital. Construction Co. is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing. While Construction Co. has identified various goods and services that will be provided during hospital construction that might otherwise be distinct (because the individual goods and services could be sold separately by the contractor or the customer could benefit from the goods or services on its own or together with other readily available resources), Construction Co. notes that the goods and services to be provided under the contract are highly interrelated and require Construction Co. to provide a significant service to integrate the goods and services into the finished hospital. In addition, the bundle of goods and services are significantly customized to construct the hospital and fulfill the contract. As a result, Construction Co. would account for the bundle of goods and services as a single performance obligation. Revenue for the single performance obligation would be recognized over time by selecting an appropriate measure of progress toward complete satisfaction of the performance obligation (assuming the criteria are met for satisfaction of a performance obligation over time (see Measuring Progress toward Complete Satisfaction of a Performance Obligation section). Under current construction contract guidance, the unit for the accumulation of revenues, costs and the measurement of income is usually a single contract, but if specified criteria are met, a vendor may identify units that are segments of a contract. However, under the proposed standard, a vendor would be required to determine if goods or services in a bundle of promised goods or services should be accounted for as a single performance obligation. That could result in the vendor Issues In-Depth / January 2012 / No. 12-1 11 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
accounting for all the promised goods or services in a contract as a single performance obligation. Example 3: Software License and Post-contract Customer Support A software company enters into a contract with a customer to provide a three-year software license and provide three years of bundled postcontract customer support (PCS). The software company does not sell the software or the PCS on a standalone basis. The software company accounts for the software license and PCS as two separate performance obligations based on the following evaluation: The software license is distinct even though it is not sold separately because the customer can benefit from the software license on its own without the PCS service. The PCS service is distinct because the customer can benefit from the PCS together with other readily available resources (the software license obtained from the software company in this transaction prior to delivery of PCS services). Under current software revenue recognition guidance, a vendor would be required to account for the license and PCS together as a single unit of accounting because three years of PCS is bundled along with the three years of software term license and otherwise not sold separately, resulting in the arrangement consideration being recognized as revenue over a three-year period. Example 4: Administrative Task Registration of Software Keys Company G licensed and transferred operating system software to a customer. The operating system software will not function on the customer s computer hardware without a key provided by Company G. The customer must provide Company G with the serial number from the computer hardware before Company G furnishes the necessary key. The customer ordered computer hardware from a different vendor, but the customer had not received the hardware when the operating system software was delivered. Therefore, the customer did not possess the serial number. The customer is obligated to pay for the operating system software on delivery of the software by Company G (i.e., payment is not contingent on delivery of the key). In this example, delivery of the key is contingent only on the customer s actions. Therefore, it appears that activity would not be considered to be a performance obligation. The customer has obtained control of the operating system software on delivery because it has the full use and benefit from the software. Assuming all other revenue recognition criteria have been met, Company G would recognize revenue on delivery of the operating system software because delivery of the key is an administrative activity that does not transfer a promised asset. However, in other cases, it may not be as clear as to whether certain fulfillment activities are administrative tasks that would not impact revenue recognition rather than performance obligations. See discussion on Administrative Task. Issues In-Depth / January 2012 / No. 12-1 12 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
Example 5: Rights to an Interactive Game and Online Gaming Service Media Co. enters into a contract with a customer that grants the customer the right to download an interactive game from Media Co. s catalog. Media Co. also permits the customer to play the interactive game against others via the Internet using the Media Co. network (i.e., online gaming service). Media Co. does not sell the interactive game without the online gaming service. Media Co. accounts for the interactive game and online gaming service as two separate performance obligations based on the following evaluation: The right to download an interactive game is distinct even though it is not sold separately because the customer can use and benefit from the interactive game on its own without the online gaming service. The online gaming service is distinct because the customer can use and benefit from the online gaming service together with other readily available resources (the interactive game obtained from Media Co. in this transaction prior to delivery of online gaming service). Customer Option for Additional Goods or Services. An option for additional goods or services (such as a renewal option) would constitute a separate performance obligation only if the option gives the customer a material right that it would not receive without entering into that contract (e.g., the customer effectively pays the vendor in advance for future goods or services in the current contract). If the selling price of an option that represents a separate performance obligation is not directly observable, an estimate of standalone selling price of the option would take into account: (a) the discount the customer would obtain when exercising the option, (b) any discount the customer would receive without exercising the option, and (c) the likelihood that the option will be exercised. Observations The evaluation under the proposed standard about whether a discount offered on future purchases provides a customer with a material right is similar to, but not the same as, current guidance and could lead to different units of accounting. Under current guidance, an offer of a discount on future purchases of goods or services generally is separately accounted for if it is significant and is incremental to both the range of discounts reflected in the pricing of other elements in that contract and the range of discounts typically given in comparable transactions. 17 In assessing whether an option gives the customer a material right under the proposed standard, the discount on future purchases of goods or services is considered to be a separate performance obligation if that discount is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market. The discount would not need to be incremental to the discount given for other goods or services in the arrangement to be considered a material right. This could result in the separate recognition of more 17 FASB ASC paragraphs 985-605-55-82 through 55-85, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 13 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
options under the proposed standard than under the current guidance. If the selling price of an option is not directly observable, the proposed standard requires only that the estimated selling price of an option take into account the discount the customer would obtain with and without the option and the likelihood that the option will be exercised (i.e., the intrinsic value less expected breakage). The Boards explicitly clarified in the 2011 ED that an option to acquire an additional good or service at a selling price that is within the range of prices typically charged for those goods or services does not provide a material right to the customer and is a marketing offer. This is the case even if the option can be exercised only because of entering into the previous contract. See Example 7. Practical Expedient. The proposed standard also provides an alternative accounting model for an option to obtain additional goods or services that provides a material right to the customer if these goods or services and their terms are similar to the original ones in the contract (e.g., a discounted renewal option). As a practical expedient, a vendor may allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Example 6: Sale of a Product and a Discount Voucher for Future Purchases Company A, a retailer, sells a computer and a printer to a customer for $2,000, which represents a 25% discount from the sum of their standalone selling prices. As part of the arrangement, Company A gives the customer a 25% discount voucher to be used for any purchases the customer makes in the retailer s store in the next 60 days. The voucher can be applied to purchases up to $1,000. Company A intends to offer a 10% discount on all sales during the next 60 days as part of a seasonal promotion. Under the proposed standard, because the discount voucher provides a material right to the customer that the customer would not receive without entering into that arrangement, Company A concludes that the discount voucher is a separate performance obligation. Example 32 illustrates how much of the transaction price of $2,000 would be allocated to the discount voucher. Under current guidance, because the offer of a discount on future purchases (25%) is not a significant incremental discount compared to the discount for the current transaction (computer and the printer), it would not be accounted for separately. The example below illustrates that options for customers to acquire additional goods or services at a price within the range of prices typically charged do not provide the customer with a material right. Issues In-Depth / January 2012 / No. 12-1 14 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
Example 7: Option Is Not Considered a Material Right (Based on Example 23 in the 2011 ED) A telecommunications company enters into a contract with a customer to provide up to 600 call minutes and 100 text messages each month for a fixed monthly fee. The contract specifies the price for any additional call minutes or texts that the customer may decide to purchase in any month. The company determines that the prices of the additional optional call minutes and texts are consistent with the standalone selling prices for those services for similar customers who purchase minutes and text messages on an individual basis. Therefore, even though the customer can exercise the option for any additional call minutes and text messages only because it entered into a contract, the option does not grant the customer a material right and, therefore, is not a separate performance obligation. The company recognizes revenue for additional call minutes and texts separately from the rest of the contract when the customer exercises its option to receive those additional services. That is, the transaction price for the initial contract includes only amounts to which the vendor has rights under the present contract, including variable amounts. The transaction price does not include estimates of consideration from the future exercise of options for additional goods or services (i.e., additional call minutes and texts) until the customer exercises the option because the vendor does not have a right to consideration until exercise occurs. When the customer exercises those options for additional call minutes and text messages, those would be accounted for as a separate contract and not combined with the existing contract. Sale of Product with a Right of Return. A sale of a product with a right of return would not be accounted for as a separate performance obligation under the 2011 ED. Instead, a vendor would recognize revenue for the transferred goods that the vendor is reasonably assured will not be returned, similar to current accounting. 18 A refund liability for the amount of consideration expected to be refunded to the customer for returned goods and an asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability also would be recognized. If the vendor concludes it is not reasonably assured of the amount that it will be entitled for the goods that will not be returned, the vendor would not recognize revenue for transferred goods subject to the right of return until it becomes reasonably assured of the amount to which it is entitled. The accounting for a sale of a product with a right of return under the 2011 ED is similar to the accounting under current U.S. GAAP except that the allowance for returns would be presented gross as a refund liability and an asset for recovery of transferred goods rather than as an allowance against the related receivable. 18 FASB ASC Subtopic 605-15, Revenue Recognition Products, available at www.fasb.org. Issues In-Depth / January 2012 / No. 12-1 15 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights
Example 8: Right of Return Company B sells 50 electronic reading devices at a price of $100 each for total consideration of $5,000. To determine the transaction price, Company B determines that the approach that is most predictive of the amount of consideration to which Company B will be entitled is the approach based upon the probability-weighted amount. Using this approach, Company B estimates a return rate of 6% of sales. Company B s experience is predictive of the amount of consideration to which it will be entitled. The cost of each product is $75. Company B estimates that the costs of recovering the products will be immaterial and expects that the returned products can be resold at a profit. Because Company B is reasonably assured of the expected amount of returns based on previous experience, which is deemed to be predictive, it records the following entries: Debit Credit Cash (or receivable) 5,000 Refund liability ($100 3 devices 300 expected to be returned) Revenue 4,700 To recognize sales excluding amounts related to devices expected to be returned. Asset ($75 3 devices expected to be 225 returned) Cost of sales 3,525 Inventory ($75 50 devices) 3,750 To recognize cost of sales and right to recover devices from customers. If Company B were unable to reasonably estimate the probability of a refund, then it would not recognize revenue when it transferred the electronic reading devices to its customers. Instead, Company B would recognize the entire consideration received as a refund liability and it would recognize an asset for its right to recover products from the customer on settling the refund liability. Warranties. Warranties are provided with the sale of a number of products and services in today s marketplace. Some warranties provide a customer with assurance that the product complies with agreed-upon specifications. Other warranties provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. If a customer has the option to purchase the warranty separately, the vendor would account for the warranty as a separate performance obligation because the vendor promises to provide a service to the customer in addition to the product or service. Thus, the vendor would allocate a portion of the transaction price to the performance obligation for the warranty service. If the customer does not have the option to purchase the warranty separately, the vendor would follow a cost-accrual model consistent with current U.S. GAAP to account for the promised warranty unless the warranty, or a part of it, provides the customer with a service in addition to Issues In-Depth / January 2012 / No. 12-1 16 independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a All rights