Ch. 3 Reading Acctcy

Significant Financing Components

A firm is not required to adjust the transaction price for a significant financing component if at the contract inception the period between payment and the transfer of goods or services is expected to be a year or less.

*Step 2: Identify the Performance Obligations in the Contract*

At the inception of a contract, a firm must determine its performance obligations. -- Each performance obligation is a promise to provide goods or services. *Key element:* determining whether the contract specifies (a) separate performance obligations for each of the goods or services to be provided or (b) one or more performance obligations, each consisting of a promise to provide a bundle of goods or services To what extent are the promises to provide goods or services bundled together and considered a single performance obligation? Each good or service or bundle of goods or services that is distinct is considered a separate performance obligation.

*Enforceability and Termination Rights*

Contracts *do not have to be written* in order to be considered contracts under the revenue recognition standard, but they *must be legally enforceable*. Oral contracts or implied contracts, if they are enforceable, are considered contracts

*Performance Obligations and Significant Judgments*

Firms must disclose qualitative information about their performance obligations, such as the point in time when a performance obligation is deemed to have been satisfied, the nature of the goods and services covered, and warranties provided. The firm must also disclose the aggregate amount of the transaction price allocated to performance obligations that are unsatisfied (or partially so) at the reporting date, along with an explanation of when it expects to satisfy those obligations. They also must disclose significant judgments it made in applying the standard.

*Contract Balances*

Firms must disclose the following information related to contract balances: - Beginning and ending balances of contract assets and liabilities, as well as receivables from contracts with customers. - Amount of revenue recognized in the current period that was included in the beginning contract liability balance. - Amount of revenue recognized in the current period as a result of changes in the transaction price related to performance obligations satisfied or partially satisfied in prior periods. - Explanation of how the firm's contracts and payment terms affect contract asset and liability balances. - Explanation of significant changes in contract assets and liabilities.

*Significant Financing Components*

Firms must identify any significant financing components in contracts with customers Financing components exist when the timing of the payment does not coincide with the time of the satisfaction of the performance obligation. Financing components can be either financing of the customer by the seller firm or vice versa.

*Collectibility versus Price Concessions*

*If a firm believes it will not ultimately receive the full, stated contract price*, judgment may be necessary to determine if the shortfall is due to a collectibility problem or a price concession. ex. The hospital determines that based on similar situations in the past, it expects the patient to pay $1,000 to settle the bill of $10,000. - A contract has been identified and the transaction price is $1,000, the amount the hospital expects to be entitled to collect. - The $9,000 is considered a discount or a price *concession*, not a failure to collect, because the patient never agreed to pay $10,000.

*Step 3: Determine the Transaction Price*

*the amount of consideration the firm expects to be entitled to receive, excluding amounts collected on behalf of third parties, such as for sales taxes* Noncash consideration is to be valued at fair value. The transaction price may have both fixed and variable components.

*Factors that indicate two or more promises to transfer goods or services are not separately identifiable include:*

- The entity provides a significant service of integrating the goods or services with other goods or services promised in the contract. - One or more of the goods or services significantly modifies or is significantly modified by other goods or services promised in the contract. - The goods or services are highly interdependent or interrelated.

*5-STEP REVENUE RECOGNITION MODEL*

1. Identify the contract(s) with a customer. 2. Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

*The customer is considered to have the right to access the firm's intellectual property if all of the following criteria are met:*

1. The firm expects to undertake activities (after the time of the transaction) that significantly affect its intellectual property. 2. The customer's rights expose it to positive or negative effects of the firm's activities. 3. The firm's activities do not result in a transfer of goods or services to the customer. If all of these criteria are met, the customer has a right to access the firm's intellectual property, and revenue is recognized over the period of the license. Otherwise, the customer has the right to use the firm's intellectual property as it existed at the time of the transaction, and revenue is recognized at that point in time.

ex. Suppose a retailer sends a "customer appreciation dividend" to each of its customers annually. It is a coupon for a discount of 50% on all purchases in the next six months, up to a maximum discount that varies by customer. Each customer's maximum discount is equal to 10% of the prior year purchases.

For example, a customer who spent $12,000 in the prior year would get a coupon for 50% off on all purchases, up to a maximum savings of $1,200. In this scenario, a performance obligation is created because customers obtain a right that could not have been obtained without making the prior purchases and the right entitles them to purchase goods for less than their stand-alone prices.

*Contract Modifications*

May be treated as - part of an existing contract OR - a new contract *A modification is considered a new, separate contract if both of the following are true:* - The modification adds distinct goods or services to the agreement. - The increase in the contract price reflects the stand-alone selling price of the additional goods or services. Then the five-step model is applied to the contract modification in the same way it would be if the additions to the contract were a new contract.

Life Sciences:

Most life sciences companies indicated there was not a significant effect on revenue reported on product sales. Revenue from certain manufacturing for private labels (i.e., there is no alternative use) is now recognized over time rather than at a point in time. Revenue on products having received regulatory approval but where pricing is not fixed or determinable because of ongoing negotiations over reimbursement rates will now be estimated under the variable revenue guidance in ASC Topic 606, rather than deferring revenue recognition until the price is set.

Technology Industry:

Revenue from most software licenses is now more commonly recognized at a point in time rather than ratably over time because of the relaxation of the evidence requirement to recognize at a point in time. Custom products that cannot be sold to other customers (i.e., have no alternative use) are now recognized over the production period rather than upon delivery. Customer options to purchase additional copies of software may now be deemed to be separate performance obligations. The decision as to gross or net presentation is different in certain situations. Warranties are now deemed to be separate performance obligations when they include preventative maintenance. Consideration payable to customers is now estimated rather than based on the maximum potential amount. Revenue is recognized sooner under ASC Topic 606 than previously when there are multiple-element arrangements.

Another Deloitte study16 reviewed comment letters sent as of August 2018 and found the comments related to the following issues:

Significant judgments (35%) Identifying performance obligations (20%) Contract acquisition costs (15%) Disclosure of disaggregated revenue (5%) Other (25%)

In the Deloitte study previously mentioned, it was found that about half of all firms disclosed prior to the effective date of the new standard that they expected no material financial effects from adopting it.15 The industries that were more likely to expect a material impact (and the reasons for them) were:

Travel and hospitality (loyalty programs; contract acquisition costs) Technology (acceleration of revenue in integrated product offerings; commissions) Aerospace and defense (measurement of progress during a contract) Retail (product returns; commissions; gift cards) Energy, life sciences and health care, and real estate investment trusts were the industries most likely to expect no material financial statement effect.

*CONTRACT ACQUISITION AND FULFILLMENT COSTS*

Under ASC Topic 606, the incremental costs of acquiring or fulfilling a contract must be capitalized and amortized over the life of the contract. Costs that would be incurred regardless of whether a contract is obtained are not capitalized ex. the costs of trying to acquire a contract, such as costs incurred to participate in a competitive presentation and bidding process, are expensed as incurred the capitalization requirement is subject to a practical expedient. If the amortization period for the costs would be one year or less, then they need not be capitalized, but rather may be immediately expensed.

Promised goods or services that are not distinct

are combined until they comprise a distinct bundle, which is then considered a single performance obligation ex. An order placed by an automobile parts supplier for many different inventory items would consist of many separate performance obligations as it is possible to identify the obligation to transfer each element of the order individually and the customer could benefit from fulfillment of a portion of the order.

*Warranties*

provide repair services for goods sold to a customer *2 purposes:* 1. they can be used to assure the customer that the product it is purchasing is *free of defect at the time of the purchase* 2. act as a sort of *insurance policy against future repair* and maintenance costs - act as a sort of insurance policy against future repair and maintenance costs

Agent

reports revenue only for the net amount retained (e.g., its commission) may recognize revenue when its performance obligation to the principal is satisfied

*A warranty is considered a separate performance obligation if*

(a) the customer has the option to purchase the warranty separately or (b) the warranty provides services beyond what is required to assure the product is free of defects at the time of sale A warranty that assures the product is free of defects is not a distinct performance obligation - it is one of the many costs of producing and selling the good, integral to that production - The cost of providing the warranty is estimated and expensed in the period in which revenue is recognized for the good whose quality it assures.

*Combining Contracts*

2 or more contracts entered into around the same time with the same customer should be treated as a single contract - if the contracts were negotiated together and have a single business purpose. if the amount to be paid under one contract depends on the price or performance of another contract, the contracts should be treated as a single contract.

*Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation*

A performance obligation is *considered satisfied when control over the goods and services that comprise the performance obligation is transferred to the customer.* *Indicators:* The customer has a legal obligation to pay the firm. The customer has legal title (in the case of goods). The customer has physical possession (in the case of goods). The customer is subject to the risks and rewards generally associated with ownership. The customer has indicated its acceptance of the goods and services. (at a distinct point of time or over time)

ASC Topic 606 provides *indicators that a firm is an agent rather than a principal:* (None of these indicators is decisive.)

Another party has primary responsibility for fulfilling the contract terms. The firm does not bear any inventory risk. The firm does not control the prices of the goods or services. The firm's consideration is in the form of a commission. The firm does not bear any credit risk related to the customer.

FINANCIAL STATEMENT EFFECTS OF ASC TOPIC 606

Connor Group examined the financial statements of technology and life sciences companies (biotech, pharmaceuticals, and medical devices) adopting ASC Topic 606 early and found the following key financial statement effects in those industries: Tech Life Science

Reversals of Impairments

As noted earlier, contract acquisition costs are capitalized and amortized. They are also subject to impairment. Under IFRS, impairments may be reversed in later periods. Impairment reversals are not permitted under U.S. GAAP.

Applying the Model to Contract Modifications

As we discussed earlier, a contract modification is a change in the scope and/or price of the contract. In some contract modifications, distinct goods or services are added to the contract, and in others they are not.

Amortization and Impairment

Capitalized contract costs are amortized in a pattern that is consistent with the recognition of revenue for that performance obligation. The amortization period may include *anticipated contracts.* ex. suppose a cable company installs equipment at a customer's residence at no charge as long as the customer signs a two-year agreement for cable service at a cost of $100 per month. The cable company does not sell the equipment on a stand-alone basis and the customer cannot benefit from the equipment without the accompanying cable service. So, there is a single performance obligation; that is, the installation of the equipment is not distinct. Suppose further that, on average, customers who undertake this particular offer stay with the cable company for five years, not just the required two years. That is, there is an anticipated contract. The cost of installing the equipment would be amortized over five years. Initially, a contract asset is established equal to the cost of installing the equipment. One-sixtieth of that cost is eliminated and a corresponding amortization expense is recognized each month over the next five years. A contract asset is written down if it is deemed to be *impaired*, in which case a loss is recognized. -- A contract asset is impaired if *the carrying amount exceeds the recoverable amount*. The recoverable amount is the remaining expected consideration to be received less the costs of providing the goods and services that have not yet been recognized in expense.

*Retrospective Approach—Practical Expedients*

Contracts that began and completed in the same year did not need to be restated. This expedient may seem to be of questionable importance because for such contracts, revenue would have been recognized in a single period in its entirety under both the old and the new rules. However, it did have several effects: - If under the new standard there were multiple performance obligations that were not separately identified under the old standard, they did not need to be separated. Consider, for example, a company that offers free services with the purchase of a product and previously accounted for the cost of the services as a sales incentive. The firm was not required to restate and separate the services into a distinct performance obligation. - If revenue was recognized previously on a contract at a point in time and it would, under the new standard, be recognized over time, it did not need to be restated. - Contracts that began and ended in a single year but spanned two or more interim periods did not need to be restated. Rather than applying the variable consideration rules to each prior period as those rules are stated, firms could use the transaction price as of the date on which the contract was completed. This approach essentially allowed for the use of hindsight that would not have been available if the new standard had originally been applied for the prior periods. Rather than determining what estimates they would have made at various points in time, they could simply assume those estimates would have been for the amounts that ultimately proved to be correct. Firms did not need to disclose the amount of the transaction price allocated to the remaining performance obligations or explain when the firm expected to recognize that amount for the restated periods.

*Step 1: Identify the Contract(s) with a Customer*

Customer = (a) party that has contracted with an entity to obtain goods or services that are an output of the entity's ordinary activities in exchange for consideration When there are multiple parties to a contract, identifying the customer can be complex *Conditions must be met* for a firm to account for a contract with a customer under the five-step model in ASC Topic 606: 1. All parties to the contract have *approved the contract* and are *legally obligated* to perform their obligations under the contract. 2. *Each party's rights* regarding the goods or services being exchanged *can be identified*. 3. *Payment terms can be identified*, although consideration may include a variable component. 4. The *contract has commercial substance*. Commercial substance means the *amount, timing, and/or uncertainty of the firm's future cash flow stream has changed as a result of the contract.* 5. *Collection is probable.* Assessment of collectibility "is based on whether the customer has the ability and intention to pay the consideration to which the entity will be entitled," as part of the determination of commercial substance.

A common source of variable consideration is the existence of bonuses or penalties based on the timeliness of completion of a construction project.

For example, suppose in 20X1 a company agreed to construct a factory for a contract price of $30 million, with a promised completion date of December 31, 20X3. If the project is completed by October 31, 20X3, the company will receive an $8 million bonus. If it is completed by November 30, 20X3, the bonus is $5 million. However, if the project is completed after December 31, 20X3, there is a $2 million penalty. There are more than two outcomes, so a probability-weighted expected value is most appropriate. Suppose the company estimates there is a 70% probability the project will be completed on time, a 10% probability it will be completed by October 31, a 15% probability it will be completed by November 30, and a 5% probability it will be late. These probabilities are based on past experience with similar projects. The following analysis shows the probability-weighted expected transaction price is $31.45 million.

*Additional Disclosure Requirement for Firms Using Cumulative Effect Approach*

For firms that employed the cumulative effect transition approach, the income statement in the year of adoption was not presented on a basis comparable to prior periods. As a result, these firms were required to present a line-by-line explanation of the effect of the change on the income statement in the year of adoption. Through this disclosure, financial statement users were able to assess revenue growth in the year of adoption (most likely 2018) by comparing revenue under the old rules to the prior period. In the following year (i.e., 2019), they were able to assess revenue growth by comparing 2019 revenue to 2018 revenue under the new rules.

distinct

For goods or services to be considered distinct, the customer must be able to benefit from the separate goods or services and the firm's obligation to transfer them must be separately identifiable from other promises in the contract. - obligation must be distinct in the context of the contract EX. if a firm has entered into a contract to construct a factory, there is a single performance obligation because the firm's obligations to transfer the individual components of the factory (foundation, walls, plumbing, etc.) are not distinct in the context of the contract -- Even though the components are capable of being distinct, in the context of this contract, there is a single, identifiable obligation to transfer the factory and all its component goods and services ex. four distinct performance obligations: the software license, the installation, the software updates, and the technical support

*EFFECTIVE DATES AND TRANSITION*

For public U.S. entities, ASC Topic 606 became effective for annual periods beginning after December 15, 2017 (2018 for calendar-year entities). Originally, the standard was to be effective for annual periods beginning after December 15, 2016. However, in 2015 the FASB delayed by one year the effective date of the standard. Nonpublic U.S. entities were required to adopt ASC Topic 606 for annual periods beginning after December 15, 2018 (i.e., 2019 for calendar-year firms). The IASB also delayed its effective date by one year, to annual periods beginning on or after January 1, 2018. Early adoption was permitted under both U.S. GAAP and IFRS. According to a study by Deloitte, about 85% of ASC Topic 606 adopters used the cumulative effect approach, although the retrospective approach was more common among firms where the financial statement effects of the changeover were more pronounced

*Assessing Whether the Firm Is a Principal or an Agent*

For transactions involving more than two parties, a firm may need to determine whether it is a principal (providing goods or services) or an agent (facilitating the sale of goods or services by another party). The principal-agent determination affects - whether a firm recognizes revenue on a gross or a net basis. - the timing of the revenue recognition

Practical expedients are permitted in the application of the new revenue recognition standard.

Generally, these practical expedients allow firms to use less complicated methods in situations where it is likely the result will not differ materially from a more rigorous application of the standard. Contract modifications are dealt with differently depending on whether they are considered new, separate contracts or not.

In contrast, ASC Topic 606 provides a single, five-step model that is to be applied by all firms in determining when revenue may be recognized:

Identify the contract(s) with a customer. Identify the performance obligations in the contract. Determine the transaction price. Allocate the transaction price to the performance obligations in the contract. Recognize revenue when (or as) the entity satisfies a performance obligation.

Under FASB ASC Topic 606, which took effect in 2018 for calendar-year firms, the determination of when revenue is to be recognized is based on a five-step model.

Identify the contract(s) with a customer. Identify the performance obligations in the contract. Determine the transaction price. Allocate the transaction price to the performance obligations in the contract. Recognize revenue when (or as) the entity satisfies a performance obligation. The result is that any contract or group of contracts with a customer results in one or more performance obligations. A performance obligation represents the goods or services the firm must provide in order to be entitled to receive the consideration it has been promised. The firm then determines the transaction price associated with each performance obligation, the transaction price being the amount to which the firm expects to be entitled upon satisfaction of the performance obligation. Determining the transaction price might require an allocation when two or more performance obligations are present in a single contract. Revenue is then recognized when or as the performance obligation is satisfied. In some circumstances, revenue is recognized at a distinct point in time. In other circumstances, revenue is recognized over time.

Measuring Progress When a Performance Obligation Is Satisfied over Time

If a firm has the right to invoice the customer at an amount that corresponds directly with performance to date, then that amount may be recognized as revenue. In other words, the amount permitted to be invoiced may be used as the measurement of the extent to which the performance obligation has been satisfied.

If a contract is determined to be a license, then the firm must determine if the license is a distinct performance obligation.

If it is not, the firm applies the five-step model for a combined bundle that represents a single performance obligation. If the license is distinct, then the firm must assess whether the customer has a right to access the firm's intellectual property. -- The conceptual issue that must be dealt with is whether the customer has the right (a) to access the firm's intellectual property as it exists at any point in time over the term of the license or (b) to use the firm's intellectual property as it existed at the time of the transaction.

Contract Modification Not a New, Separate Contract

If the contract modification adds goods or services that are distinct from those that have already been transferred, but the incremental contract price is not commensurate with the stand-alone price of the additional goods or services, then the original contract is considered to have been cancelled and a new contract entered into. The firm then accounts for each of the performance obligations under the revised contract as if it had just entered into the contract. If the contract modification does not add goods or services that are distinct from those that have already been transferred, then there is a cumulative catch-up adjustment. Revenue is recognized in the current period such that the cumulative amount of revenue recognized to date is equal to the amount that would have been recognized had the modified contract been the contract that was originally entered into. This approach is similar to that used for a price change.

The Meaning of Collectibility

In Step 1 of the revenue recognition model, a contract is identified. In order for the contract to be within the scope of the standard, collection must be considered probable. The term "probable" has different meanings in IFRS and U.S. GAAP. Under IFRS, collection is probable if it is more likely than not, meaning above 50% probability, to occur. Under U.S. GAAP, probable means likely. Although there is no numerical probability cutoff associated with that term, it is a higher threshold than "more likely than not."

*Revenue Recognition Transition at Apple Computer*

In its Form 10-K for the year ended September 29, 2018, Apple Computer disclosed that it would adopt ASC Topic 606 at the beginning of the next fiscal year, fiscal 2019, as required by the standard. It also disclosed that it would use the full retrospective transition method. On January 2, 2019, Tim Cook, Apple's chief executive officer, provided "earnings guidance" to investors via a letter in which he estimated that revenues of Apple's strategically important Services business in the first quarter of fiscal 2019, which ended on December 29, 2018, were more than $10.8 billion. That figure was above analyst expectations. However, some analysts had forgotten that fiscal 2019 revenue numbers would be based on the new standard. Several days later, Apple posted an analysis of how the retroactive restatement of fiscal 2018's results would affect the previously reported fiscal 2018 quarterly revenue amounts by line of business. That disclosure showed that first-quarter fiscal 2018 Services revenue would be restated upward by $658 million. Analysts who were basing their Q1-2019 revenue expectations on an amount by which they thought Q1-2019 would exceed Q1-2018 realized that an apples-to-apples (no pun intended) comparison to Cook's $10.8 billion estimate required their expectations level to be $658 million higher than the number they were using. Suddenly the Services business appeared to miss, rather than beat, the analysts' revenue expectations. The lesson here for anyone analyzing a company's results when there are accounting changes is that understanding the transition to the new standard is critically important. And it is important to be sure when a company makes disclosures to understand the basis on which those amounts were determined; that is, is it the new standard or the old one and does that match how you determined your benchmark?13

*Customer Options*

In some cases, customers have an option to acquire additional goods or services. - In those cases, an evaluation is required to determine if such an option creates an additional performance obligation. If the customer could obtain the same rights to additional goods or services without entering into the agreement, or if the option provides the right to purchase the goods or services at the stand-alone selling price for those goods or services, then no additional performance obligation is created. If the customer could NOT have obtained the same rights without entering into the agreement and the rights call for either free or discounted goods or services, then a material right exists and an additional performance obligation is created.

Disclosure Requirements

Interim disclosure requirements are less extensive under IFRS than under U.S. GAAP.

Answers to the following questions will be useful in distinguishing between an assurance warranty and a warranty providing additional services:

Is the warranty required by law? If so, it is more likely an assurance warranty because such laws typically are designed to assure the quality of the product being sold, rather than requiring additional post-sale services to be provided. What is the length of the warranty? The longer the warranty period, the more likely it covers repairs that were not caused by unseen defects at the time of sale. The length of the warranty should be considered in the context of the length of time it typically takes defects to manifest for a given product. What are the services required under the warranty? If a warranty covers services that would normally be considered routine maintenance, like oil changes for an automobile, then it is not (or at least a portion of the warranty is not) an assurance warranty.

If a performance obligation is satisfied over time, then the firm must determine, at each reporting date, the extent to which the performance obligation has been satisfied. *2 categories of methods that may be used for this measurement:*

Output methods - directly measure the value of goods and services transferred to date and yet to be transferred - may be certain milestones reached that indicate a certain proportion of the value has been transferred, appraisals of results achieved, or other measures focused on output Input methods - measure the inputs or effort expended as a proportion of the total - ex. costs incurred as a percent of the estimated total costs, labor hours expended as a percent of the estimated total labor hours, and time elapsed as a percent of the estimated total time revenue may be recognized in proportion to the percentage of completion, based on that measuremen

*Performance Obligation Satisfied over Time*

Percentage-of-completion - a performance obligation need not go from 0% satisfied to 100% at a distinct point in time A performance obligation is satisfied over time if any of the following criteria is met: - The customer simultaneously receives and consumes the goods and services provided by the firm as it satisfies its performance obligation. - The firm's performance creates or enhances an asset under the customer's control. - The firm's performance does not create an asset with an alternative use, and the firm has a right to receive payment for its performance to date. Such payment cannot be a mere reimbursement of costs incurred; it must include a pro rata profit margin on the completed work. The first two of these criteria represent situations where the customer receives the benefits of the firm's work as it is performed. In other words, the performance obligation is partially completed with each increment of work done. The third of these criteria is not about the ability of the customer to consume the benefits, but rather about the firm's right to be compensated for the work it has accomplished to date.

Revenue recognition rules have transitioned from a patchwork of guidance that addressed specific issues individually to a robust framework for addressing revenue reporting issues.

Previous guidance often addressed issues related to a specific industry or the quirks of a particular type of transaction.

*Licenses*

Some transactions involving intellectual property represent a sale of intellectual property, whereas others represent licenses. The *approach to be used for revenue recognition depends on whether the transaction is considered a sale or a license.* SALE: treated like any other sale and the five-step model is applied to determine the point in time at which sales revenue may be recognized -- If the customer's use of the property is unlimited LICENSE: revenue recognition may be entirely at the inception of the license or over time during the period of the license, depending on the circumstances -- If the customer's right to use the intellectual property is somehow limited, for example, by time or geographic area EX. if you download a movie and pay a fee for the download, and you are now entitled to view the movie as many times as you wish with no additional charge, the transaction is a sale, and the seller may recognize revenue at the time of the download. If you pay a fee for the right to download movies for a specified period of time, the transaction is a license, and revenue recognition is based on a determination of when the performance obligation is satisfied.

*Consideration Received before a Contract Exists*

Sometimes a *payment is received before a contract can be identified* under Step 1. When that is the case, revenue may be recognized when the consideration is nonrefundable and any one of the following events has occurred: -- There are no remaining obligations to transfer goods or services to the customer. -- The contract has been terminated. -- The entity has transferred the goods or services to which the consideration received relates, and it has no further obligation to transfer goods or services. If a contract exists and a payment is received before the entity satisfies its performance obligation(s) under the contract, the discrepancy between when the payment is received and when the obligation(s) is (are) satisfied is considered a significant financing component. Performance obligations and significant financing components are discussed in Step 2 of the model.

SEC COMMENT LETTERS ON REVENUE RECOGNITION

The SEC regularly sends comment letters to registrants when questions are raised by their reviews of filings. Sometimes these letters result in a finding that there were errors in the financial statements or other disclosures. Other times the SEC is just asking for clarification about why a particular judgment was made or how the firm accounted for some item. Comment letters sent to firms about the new revenue recognition standard are a useful way to see what issues have been most problematic for firms in the implementation of the standard.

*Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract*

The allocation of the transaction price should be based on the stand-alone prices for the goods and services comprising each performance obligation. When the sum of the stand-alone prices is NOT equal to the total consideration, the allocation of the consideration should be based on the proportion of the sum of the stand-alone prices represented by each performance obligation. When the goods and services in the contract are also sold separately, it is straightforward to determine the respective stand-alone prices. Otherwise, estimates must be made. - An estimated stand-alone price may be based on an adjusted market approach, an expected cost plus margin approach, or a residual approach. Under an adjusted market approach: the firm estimates the amount a customer would be willing to pay for the good or service on a stand-alone basis. This would likely be done by observing prices for similar goods or services, with adjustments to reflect differences between the observed goods or services and the one for which the stand-alone price is being estimated. The cost-plus approach: uses an assumed reasonable profit margin to determine the stand-alone price. The residual approach: is appropriate only when the stand-alone price of one or more of the goods or services (a) is highly variable or uncertain, perhaps because it depends on negotiations with each individual customer, or (b) cannot be established because the goods or services have not been sold on a stand-alone basis. The residual approach essentially "plugs" one of the performance obligations as the difference between the total consideration and the sum of the stand-alone prices for all the other performance obligations.

Portfolio Approach

The five-step model may be applied to a portfolio of contracts with similar characteristics rather than to individual contracts if the firm reasonably expects that the financial statements would not be materially different.

*DISCLOSURE REQUIREMENTS*

The new standard requires extensive supplemental disclosures.

Contracts with customers give rise to performance obligations, representing the goods or services a firm has obligated itself to provide.

Transaction prices are allocated to performance obligations and revenue is recognized when (or as) the performance obligations are satisfied.

*GLOBAL VANTAGE POINT*

The revenue recognition standard was a joint project of the FASB and the IASB, and the two standards are substantially converged. Still, there are some differences between the IFRS version and the U.S. GAAP version.

Practical Expedients in Applying the Model

The standard permits several practical expedients, which allow a firm to use a simpler approach because it is not expected that the deviation from a more rigorous application of the standard would be material.

*Consideration Payable to a Customer*

There are situations when consideration is due to the customer ex. slotting fees, advertising, and rebates Depending on the circumstances, this consideration may represent a discount on the price of goods or services promised to the customer, or a separate transaction involving the purchase of goods or services from the customer. If the consideration due to the customer is NOT a payment for distinct goods or services, or it is for distinct goods or services whose fair value CANNOT be reasonably estimated, -- then the *payment is considered a reduction in the transaction price* for the goods or services promised to the customer. If the payment due to the customer is for goods or services whose value can be reasonably estimated, -- then the amount due to the customer is treated as a *separate transaction*—a purchase of goods or services. -- if the consideration due to the customer exceeds the estimated fair value of the goods and services being acquired from the customer, then the excess is treated as a reduction in the transaction price for the goods or services promised to the customer.

Contract Modification a New, Separate Contract

We saw in Step 1 that if the contract modification adds goods or services that are distinct from those that have already been transferred and the incremental contract price is commensurate with the stand-alone price of the additional goods or services, then the additional goods or services are treated as a separate contract.

*Price Changes*

When there is a price change, the price associated with each performance obligation is reallocated process may affect the revenue recognized for each of those performance obligations

*Franchise Agreements*

convey a right to access certain intellectual property, such as trade names the owner of a restaurant that operates under a franchise agreement with a major restaurant chain accesses intellectual property as it exists at any point in time over the term of the franchise agreement The franchisee benefits from advertising and other marketing efforts that occur over time. However, to the extent that a franchise agreement has other elements to it, such as the provision of training, assistance with site selection, or other goods or services, the agreement may need to be separated into several performance obligations, only one of which is the right to access intellectual property.

When the firm is financed by the customer (payment is made before the performance obligation is satisfied)

deferred revenue is recognized when the payment is received and interest expense accrues until the time revenue is recognized DR: Cash CR: Deferred revenue DR: Interest expense CR: Deferred revenue DR: Deferred revenue CR: Sales revenue

*Variable Consideration*

ex. volume discounts, rebates, refunds, performance bonuses, and consideration that depends on a future event estimated at the contract's inception and is reassessed at each financial statement date. The estimate may be either a probability-weighted expected value or a most likely amount. - should be the approach that best predicts that amount of consideration to which the firm will be entitled Most likely amounts - are more appropriate in situations where there are only two outcomes, such as the achievement of a performance bonus (or not). Probability-weighted estimate or a most-likely amount estimate - variable consideration is constrained not to exceed an amount such that it is probable a significant reversal will not be required. - a higher probability threshold than the 50% associated with the phrase "more likely than not." A likely consequence of variable consideration is a change in the transaction price.

*Consignment Arrangements*

exists when a firm delivers goods to another party but retains control over them. The purpose of the arrangement is typically to facilitate a sale to a third party. *Indicators that a consignment agreement exists are as follows:* - The firm transferring possession of the product still controls it until some event occurs, such as the sale of the product to a third party. - The firm transferring possession of the product has the right to require the product to be returned or transferred elsewhere. - The entity that has received the product is not obligated to pay for it (unless it is sold). ex. Suppose a clothing manufacturer delivers goods to a department store. The store must pay an agreed-upon amount to the manufacturer for each unit of clothing sold. At any time during the agreement, the manufacturer may direct the store to return the clothing or to transfer it to another store, and the manufacturer must accept the return of any unsold units. Clearly, this arrangement is a consignment. Revenue is not recognized until the consigned goods are sold to a third party.

*Right of Return*

exists when the customer is entitled to a full or partial refund, a credit against amounts owed, or another product in exchange (unless it is only for another product that is essentially the same) the amount the firm will be entitled to collect depends on the extent to which customers exercise their rights to refunds. DR Cash CR Sales revenue CR Refund liability Estimated returns also affect the amount of cost of goods sold to be recognized: DR Cost of goods sold DR Inventory recovery asset CR Inventory

*Disaggregated Revenue*

firms must disaggregate revenues into categories that depict how revenue is affected by economic factors revenue may be disaggregated by geographic region, type of goods and services, type of customer, or other categorizations the firm deems relevant. The firm must also disclose the relationship between the disaggregation and how segment disclosures are disaggregated. The standard does not specify a minimum number of categories that must be provided.

A firm is considered a principal if

it obtains control of the goods or services and then transfers that control to another party A principal recognizes revenue for the gross amount paid by the customer and reports as an expense its cost of goods sold. may not recognize revenue until the goods or services promised to the end customer have been transferred

*Gift Cards*

represent a particular type of prepayment Amounts received for the purchase of gift cards are not recognized as revenue when the cards are sold, as no goods or services have yet been transferred to customers. If it were certain that all gift cards would eventually be redeemed, then the accounting would be straightforward. However, it is typical that a portion of gift card balances will go unused. This unused portion is referred to as "breakage." Estimated breakage may be recognized as revenue in proportion to the usage of the gift cards. However, breakage can be recognized only to the extent that it is probable a reversal will not be necessary. The extent to which firms' gift card liabilities will be affected by ASC Topic 606 depends on the magnitude of their use and how the firms were accounting for the gift cards in the past, as there has been diversity in practice. DR: Gift card liability CR Sales revenue CR Breakage revenue

*Bill-and-Hold Arrangements*

the firm bills a customer for goods but retains physical possession at the customer's request, often due to the customer's physical space constraints Revenue may be recognized when control is transferred to the customer. For control to be considered transferred, all of the following criteria must be met: - The reason for the bill-and-hold arrangement is substantive. - The product is identified separately as belonging to the customer. - The product is ready for physical transfer to the customer. - The firm does not have the ability to use the product itself or to transfer it to another customer. If all of these criteria are met, then control is deemed to have been transferred to the customer. It may obtain the asset physically at any time. The seller is simply providing temporary storage until the customer is ready to accept delivery. the seller may recognize revenue

When the customer is financed by the firm (payment is made after the performance obligation is satisfied)

the recognition of revenue results in the simultaneous recognition of a receivable DR: Notes receivable CR: Sales revenue DR: Cash CR: Note receivable

*General Dynamics Disclosure*

the revenue note from General Dynamics's 2017 Form 10-K Begins with a discussion of how performance obligations are determined. It indicates that most of the company's contracts consist of a single performance obligation, but it also discusses how the purchase price is allocated when a contract involves more than one performance obligation. It also indicates that most of the company's performance obligations are satisfied over time and that the most common measure of performance obligation satisfaction is the amount of cost incurred, an input measure. The note then discusses how estimates are made. The schedules of revenue by category satisfy a key disclosure requirement in ASC Topic 606. - First, the revenue is disaggregated by major products and services. - This disaggregation permits the reader to assess trends in revenue growth in a way that is not possible with full company numbers. - Product lines within each of these groups varied as well. The next schedule breaks out for each product group the revenues by contract type. About two-thirds of General Dynamics's revenues are from fixed-price contracts. As the discussion in the note explains, such contracts are riskier but potentially offer a greater reward, as the economic impact of all cost savings and cost overruns are borne by the company. - Finally, the disclosure indicates that about two-thirds of the company's revenues are from contracts with the U.S. government. And the company also discloses information about its contract balances.

transition methods

used to implement changes in accounting methods in detail The two transition methods that were permitted when ASC Topic 606 was adopted were the retrospective approach and the cumulative effect approach.