Accounting news 07 US GAAP. 02 Czech Accounting 05 IFRS. Winning is a state of mind. IFRS Tips IFRS EU Endorsement Process

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1 Winning is a state of mind Accounting news Czech Accounting, IFRS and US GAAP May 2012, Deloitte Czech Republic 02 Czech Accounting Deferred Tax Pursuant to IFRS and Czech Real Estate Regulations 05 IFRS IFRS Tips IFRS EU Endorsement Process 07 US GAAP How the Converged Revenue Recognition Model May Affect Sales Targets

2 Czech Accounting Deferred Tax Pursuant to IFRS and Czech Real Estate Regulations In this issue, we bring an article which was written by Petra Bajgerová and published this month in the Auditor magazine. Deferred Tax Definition and Principle Deferred tax is defined in IAS 12 Income taxes. The basic definition of deferred tax matches the definition provided in Czech Accounting Regulations. Deferred tax is calculated based on temporary differences between the accounting and tax values of assets and liabilities. Temporary tax differences originate as a result of a different treatment of including the relevant item or transaction in the tax base and the accounting profit or loss. If the tax expense in the reporting period exceeds the accounting expense, the tax base in the reporting period will be lower than the accounting profit. In the following periods, the situation will reverse and the tax base will exceed the accounting profit. The consequence of this situation is a fluctuation in the tax payable and subsequently also the net profit in periods in which the profit before tax is identical. This situation is addressed by International Financial Reporting Standards through deferred tax accounting. If the tax base is lower than the accounting profit and the difference can be regarded as temporary, deferred tax is charged to expenses and credited to payables. The difference is called a taxable difference. In the opposite case, deferred tax is charged to receivables and credited to income and the difference is called a tax deductible. When the temporary difference subsequently reverses, the deferred tax is released in the period and to the extent to which the temporary difference is reversed. The concept of deferred tax can be regarded as a consequence of the application of one of the three major accounting principles the accruals principle. If we apply this principle to income tax, we have to calculate the tax expense from all tax-deductible expenses 02 and income that are related to the relevant period, not only from those that are acknowledged by the tax regulations in the relevant period. The base for deferred tax also includes the tax-deductible loss which can be used to decrease the tax base in the following periods, ie over the period of five years in our conditions. The principle applied in the case of tax liabilities is that the company will record all tax liabilities in its financial statements, regardless of their due dates. The principle that applies to assets is that the tax asset can be recognised only in cases in which it is highly likely that the company will realise benefits arising from these assets, ie that the collection or realisation of these assets as part of the settlement of the tax liability with regard to future taxation periods will take place. The deferred tax is calculated at the anticipated tax rate valid at the balance sheet date in the period of settlement of the deferred tax. Deferred tax is not discounted. According to IAS 12, deferred tax must be recognised every time that temporary tax differences originate. Pursuant to Section 59 of Regulation 500/2002 Coll., deferred tax must be accounted for if the company is obliged to have its financial statements audited pursuant to Section 20 of the Accounting Act; in the case of joint stock companies, deferred tax must be recognised regardless of the audit obligation. Furthermore, deferred tax is recognised in the case of companies that are included in a consolidation group. In other companies, the recognition of deferred tax depends on their decision. Deferred Tax in the Case of Acquisitions under IFRS Accounting for company acquisitions is regulated by IFRS 3 Business Combinations. The basic requirement of the standard is the measurement of assets and liabilities at fair value at the date of acquisition, while the tax values remain the same; thus, temporary tax differences originate that form a basis for the deferred tax according to IAS 12. The only exception is goodwill, with regard to which no deferred tax arises; the value of goodwill is nevertheless influenced by the deferred tax. The calculation of the deferred tax will be demonstrated on a simplified case of acquisition: Company X acquires Company Y, the transaction price is CZK 20,000 thousand. The tax rate for Company Y is 19%. On the face of the balance sheet, Company Y records the following assets in the accounting net book values, which equal the tax carrying amounts, and records no payables: Land Buildings Other assets CZK 6,000 thousand CZK 8,000 thousand CZK 500 thousand The total accounting and tax value of the assets amounts to CZK 14,500 thousand. Based on an expert appraisal, the fair values of the assets are: Land Buildings Other assets CZK 8,000 thousand CZK 10,000 thousand CZK 500 thousand The total fair value of the assets amounts to CZK 18,500 thousand. The deferred tax base is the difference between the accounting (tax) value and the fair value, CZK 18,500 thousand - CZK 14,500 thousand, ie CZK 4,000 thousand, and the deferred tax liability arising from the revaluation of assets thus amounts to 19% of such amount, ie CZK 760 thousand. The revaluation of assets, as well as the deferred tax, is charged against equity.

3 Czech Accounting The transaction gave rise to goodwill amounting to the difference between the paid price of CZK 20,000 thousand and the amount of the revalued assets after the deduction of payables, in our case after the deduction of only the deferred tax. Goodwill is thus calculated as follows: Value of equity interest in company Y Fair value of assets Deferred tax liability Goodwill 03 CZK 20,000 thousand CZK (18,500) thousand CZK 760 thousand CZK 2,260 thousand The result is that the value of goodwill includes the difference between the price of acquisition and the fair value of assets in the amount of CKZ 1,500 thousand and the deferred tax in the amount of CZK 760 thousand. In certain countries, it is possible to achieve a zero tax effect, eg if the sale of assets is exempt from tax. In such case, the deferred tax liability would amount to zero and the goodwill would decrease by CZK 760 thousand. Deferred Tax upon the Fair Value Remeasurement of Assets under IAS 40 and IAS 16 IAS 40 Investment Property is applicable to real estate and land that is kept for lease purposes, capital appreciation, or both. It enables the measurement of assets at fair value, and the impact of the revaluation is recorded in profit or loss of the relevant period. The revaluation gives rise to deferred tax and pursuant to IAS 12, the deferred tax is recorded to the profit and loss account. IAS 16 Property, Plant and Equipment deals with non-current assets, with the exception of investment property which falls under IAS 40. IAS 16 also enables the assets to be stated at fair value, with the difference being that an increase in value is charged against equity (the revaluation is recorded in profit or loss, if the prior value decrease was charged against the profit or loss due to revaluation). The deferred tax related to items that are charged against equity is also charged against equity, or to the profit or loss, similarly to revaluation. Determining the Fair Value and the Impact of the Tax Effect When calculating deferred tax, further complications may arise, including the question as to whether the fair values of assets and liabilities have been determined by the expert before tax or whether the tax effect was reflected in the calculation. The fair value of assets is often determined as the discounted value of future net cash inflows from the asset. The discount rate can, but does not have to, involve the tax effect. The discount rate after taking tax into account is calculated as follows: discount rate before tax / (1- tax rate). Expert appraisals that operate with the tax effect will determine the fair value after tax. The following calculation is an example: Future annual net cash inflows from an asset CZK 100 thousand Discount rate without the tax effect 5% Tax rate 19% Discount rate with the tax effect 5% / (1 19%) = 6.17% The fair value of an asset can be calculated in a simplified way as perpetuity. a) Fair value before tax using the discount rate without a tax effect: / 5% = CZK 2,000 thousand b) Fair value after tax using the discount rate with a tax effect: / 6.17% = CZK 1,620 thousand The fair value thus differs significantly if the expert takes into account the income tax effect. Let us return to the example of acquisition and look at the difference between the fair value of assets while taking into account the tax effect, and without taking the tax effect into account. a) The fair value of CZK 18,500 thousand is calculated while taking the tax effect into account. Revaluation of assets in the amount of CZK 4,000 thousand, which represents a temporary tax difference, is after tax (net). The revaluation, which gives rise to a temporary taxable difference, is thus 81% of the value before tax and must be increased by 19%. CZK 4,000 thousand / (1 19%) = CZK 4,938 thousand. The deferred tax liability amounts to CZK 4,000 thousand - CZK 4,938 thousand = CZK 938 thousand. The deferred tax liability is charged against the revalued asset. b) The fair value of CZK 18,500 thousand is calculated without reflecting the tax effect Revaluation of assets in the amount of CZK 4,000 thousand, which represents a temporary tax difference, is before tax (gross). The temporary difference thus amounts to 100%. The deferred tax liability is calculated as 19% of CZK 4,000 thousand and is charged against the equity since the revaluation is also charged against the equity. In most cases, expert appraisals do not include the determination of the deferred tax. It is also problematic to differentiate whether the resulting fair value recorded in the expert appraisal already includes the income tax impact or not. The impact of the income tax is often reflected in the discount rate and the resulting value in the appraisal is a value after tax, ie the case explained in point a). The discounted cash flow method, which is often used in practice, often takes into account cash flows over the period of nine years and the last, tenth year is divided by the exit yield. The exit yield is determined based on the realised transactions on the real estate market; it is questionable whether the income tax impact has already been taken into account for the exit yield. Deferred tax related to acquisitions pursuant to Czech regulations In Czech regulations, the issue of mergers and acquisitions is regulated by Czech Accounting Standard no. 003, which states that the revaluation of assets upon transformations of companies and upon contributions of assets results in the occurrence of temporary differences that give rise to deferred tax.

4 Czech Accounting At the same time, the accounting value of assets is increased to their fair value, but the tax base remains at the original acquisition cost. In such cases, the revaluation is charged against equity and the deferred tax is thus also charged against equity. In the case of the acquisition of a business, when the buyer takes over the assets and liabilities, no temporary tax differences from the transaction arise because the revaluation of assets increases the tax input cost. It is also necessary to differentiate the acquisition of a business pursuant to IFRS 3 and Czech regulations. IFRS 3 does not apply to transactions under common control, eg mergers of two companies which have the same parent company. Pursuant to the Czech Act on Transformations, it is the merger during which the revaluation takes place and temporary differences arise that forms the basis for the deferred tax. Deferred tax with regard to the acquisition of assets difference from the acquisition of a business If an asset (eg a building) is acquired, such asset is recorded at acquisition cost, which is also the tax input cost, and no deferred tax arises. Subsequently, temporary tax differences arise as a result of different accounting and tax depreciation. The question is whether the acquisition of a company which reports only a building and land in its balance sheet represents an acquisition a business and IFRS 3 applies (share deal), or whether it should be considered an acquisition of an asset, meaning that IAS 16 or IAS 40 would apply. IFRS 3 defines a business as a set of activities and assets that is capable of being conducted and managed for the purpose of generating a profit, lower costs or other benefits. The decision as to whether it is a share deal or an asset deal is not always unanimous and requires detailed consideration. 04

5 IFRS IFRS Tips These IFRS Tips cover questions from our clients relating to IAS 2 Inventories and IAS 18 Revenue. Discounts and Rebates Background Entity A is a retailer that acquires products from manufacturers, which are then sold to end users. The manufacturers grant incentives to Entity A on one of two bases: a 10 per cent prompt settlement discount on all purchases of inventories settled within 30 days of purchase; or rebates based on the volume of merchandise purchased or sold. Question How should these discounts and rebates be accounted for by Entity A in each of the following circumstances: Entity A acts as a principal in the purchase of products from manufacturers and the sale of products to end users? Entity A acts as an agent of the manufacturers in making sales to end users? Answer Guidance on how to determine whether an entity is acting as a principal or as an agent is provided in Example 21 in the Illustrative Examples that accompany IAS 18 Revenue. The example lists the following as features that indicate that an entity is acting as a principal: a) the entity has the primary responsibility for providing the goods or services to the customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer; b) the entity has inventory risk before or after the customer order, during shipping or on return; c) the entity has latitude in establishing prices, either directly or indirectly, for example by providing additional goods or services; and 05 d) the entity bears the customer s credit risk for the amount receivable from the customer. The determination as to whether an entity is acting as a principal or as an agent will always depend on the specific facts and circumstances and it will generally be necessary to exercise judgement. The list of features above is not intended to be exhaustive. Moreover, in any particular scenario, some of the indicators may be judged more important than others, so it is not appropriate to apply a checklist approach that would give equal weight to each. Feature (a) above will frequently be considered a strong indicator of whether an entity is acting as a principal or as an agent. In accordance with paragraph 11 of IAS 2 Inventories, rebates and discounts that have been received as a reduction in the purchase price of inventories should be taken into consideration in the measurement of the cost of those inventories. Rebates that specifically and genuinely refund selling expenses should not be deducted from the cost of inventories. Entity A acts as principal If Entity A acts as principal in the sale and purchase of products then, in accordance with IAS 2.11, rebates and discounts that have been received as a reduction in the purchase price of inventories should be taken into consideration in the measurement of the cost of those inventories. Prompt settlement (cash) discounts Entity A should deduct prompt settlement discounts from the cost of the inventories. When measuring the cost of the inventories, Entity A should estimate the expected settlement discount to be received from the supplier. This is consistent with the accounting by the supplier required by paragraph 10 of IAS 18 Revenue, which states that a transaction should be measured "at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity". Volume rebates Similarly, volume rebates should be deducted from the cost of inventories. See the next question for more detailed considerations regarding when the rebate should be recognised. Entity A acts as agent If Entity A is not purchasing the products as a principal, and its sales to end users were as an agent for the manufacturers, then it will not account for the products sold on a gross basis. Instead, the rebates will form part of the net commission revenue earned by Entity A. Cash Refund based on Volume of Purchases Background On 1 July 20X1, in a binding arrangement, a vendor offers a cash refund of CZK 1,000 to a customer if during the 12 months to 30 June 20X2 the customer purchases 1,000 units of a particular product. Historically, on average, the customer has purchased 1,700 units each year and there have been no significant changes in the trading relationship in the current period. Question How should the customer account for the refund to be received from the vendor in its financial statements for the year ending 31 December 20X1 if the 1,000 unit threshold has not yet been reached? Answer The cash refund constitutes a volume rebate to be accounted for as a reduction in the cost of inventories. IAS 2.11 does not, however, specify the treatment of refunds or rebates that are anticipated but have not yet been earned or the allocation of refunds or rebates to items of inventory. Anticipation of refunds not yet earned The question regarding refunds or rebates that are anticipated but that have not yet been earned in full is addressed in IAS 34 Interim Reporting in the context of the preparation of interim financial statements, and it is appropriate to apply the principle established in IAS 34 to the preparation of annual financial statements in the circumstances described.

6 IFRS IAS 34.B23 states as follows: Volume rebates or discounts and other contractual changes in the prices of raw materials, labour, or other purchased goods and services are anticipated in interim periods, by both the payer and the recipient, if it is probable that they have been earned or will take effect. Thus, contractual rebates and discounts are anticipated but discretionary rebates and discounts are not anticipated because the resulting asset or liability would not satisfy the conditions in the Conceptual Framework that an asset must be a resource controlled by the entity as a result of a past event and that a liability must be a present obligation whose settlement is expected to result in an outflow of resources. Therefore, in the circumstances described, if it is probable that the customer will purchase at least 1,000 units in the specified period (e.g. forecast purchase levels are in line with historical volumes), the refund (which is contractual) should be accrued as the units are purchased. Units to which the refund should be allocated The refund should be allocated to the units of inventory purchased on a systematic and rational basis. If the vendor s offer of a cash refund is a one-off incentive, and not expected to be repeated, it may be appropriate to account for the refund as a reduction in the cost of the first 1,000 units purchased, because the customer s entitlement to the refund is based on the purchase of 1,000 units of inventory. Conversely, if the vendor routinely offers such a refund on an annual basis but on the condition that the customer purchases all inventories of this type from the vendor (i.e. an exclusive supply arrangement), it may be more appropriate to regard the refund as relating to all purchases in the year and account for it as a reduction in the cost of all units purchased. The assessment should be made on the basis of the specific facts and circumstances, including all relevant contractual terms. IFRS EU Endorsement Process The European Financial Reporting Advisory Group (EFRAG) updated its report showing the status of endorsement of each IFRS, including standards, interpretations, and amendments, most recently on 6 April The following 16 IASB pronouncements are awaiting European Commission endorsement for use in the EU: Standards IFRS 9 Financial Instruments (issued in November 2009) IFRS 10 Consolidated Financial Statements (issued in May 2011) IFRS 11 Joint Arrangements (issued in May 2011) IFRS 12 Disclosures of Involvement with Other Entities (issued in May 2011) IFRS 13 Fair Value Measurement (issued in May 2011) IAS 27 (2011) Separate Financial Statements (issued in May 2011) IAS 28 (2011) Investments in Associates and Joint Ventures (issued in May 2011) Interpretations IFRIC 20 Stripping Costs in the Production Phase of a Surface Mine (issued in October 2011) Amendments Amendments to IFRS 1 Removal of Fixed Dates for First-Time Adopters (issued in December 2010) Amendments to IFRS 1 Severe Hyperinflation (issued in December 2010) Amendments to IFRS 1 Government Loans (issued in March 2012) Amendments to IFRS 7 Disclosures - Offsetting Financial Assets and Financial Liabilities (issued in December 2011) Amendments to IAS 1 Presentation of items of Other comprehensive Income (issued in June 2011) Amendments to IAS 12 Deferred Tax: Recovery of Underlying Assets Amendments to IAS 12 (issued in December 2010) Amendments to IAS 19 Employee benefits (issued in June 2011) Amendments to IAS 32 Offsetting Financial Assets and Financial Liabilities (issued in December 2011) The endorsement status report can be found at 06

7 US GAAP How the Converged Revenue Recognition Model May Affect Sales Targets On November 14, 2011, the FASB and the IASB (the boards ) jointly issued their revised exposure draft ( ED ) Revenue From Contracts With Customers. The revised ED will require retail and distribution ( RD ) entities to reconsider many of their accounting policies and practices. For example, the revised ED provides specific approaches to assessing variable consideration, which may affect an entity s methods of measuring provisions for customer incentives. In limited circumstances, the timing of revenue recognition could significantly change for RD entities. For example, entities that currently account for loyalty or rewards programs as a cost accrual might instead be required to defer revenues for those programs. In contrast, entities that currently defer revenues for goods shipped with synthetic FOB destination terms might instead be required to recognize some, but probably not all, revenue associated with those goods upon shipment. The boards are expected to issue a final standard in the first quarter of Background The revised ED retained the overall model that was originally proposed, which outlined five sequential steps to recognizing revenue: 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 in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation. 07 The revised ED states that the core principle for revenue recognition is that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Although the boards did not modify the five steps to applying this principle, they did change how each step is applied as well as other aspects of the proposed model. For instance, the proposal would require capitalization of certain costs of obtaining and fulfilling a contract and would modify the criteria for recognizing losses on certain onerous performance obligations. Compared with current revenue recognition guidance, the revised ED requires significantly expanded disclosures about revenue recognition, including both quantitative and qualitative information about (1) the amount, timing, and uncertainty of revenue (and related cash flows) from contracts with customers; (2) the judgment, and changes in judgment, exercised in applying the proposal s provisions; and (3) the assets recognized from costs to obtain or fulfil a contract with a customer. Key Accounting Issues The revised ED clarifies the revenue recognition principles and includes additional guidance on certain revenue transactions. Although the revised ED may not significantly change the general revenue recognition model for normal product sales for RD entities, a number of the revised ED s proposals may differ from current practice. Discussed below are some key accounting issues that may significantly affect the RD industry. Customer Reward Points and Loyalty Programs Options that allow customers to acquire additional goods or services for free or at a discount are common in the RD industry (e.g., customer reward points, loyalty programs, contract renewal options, or other discounts on future goods or services). Under the revised ED, such an option would represent a separate performance obligation if it gives the customer a material right that it otherwise would not have received without entering into the contract. For an option that is deemed a separate performance obligation, an entity would allocate a portion of the transaction price to the option and recognize revenue when control of the good or service underlying the option is transferred to the customer or when the option expires. In certain instances, a customer may not exercise all of its rights under the option (which results in breakage of the contract liability). Under the revised ED, an entity may need to use significant judgment when determining whether the option to acquire the additional goods or services gives the customer a material right that it otherwise would not have received without entering into the contract. An entity should also use judgment when allocating the contract consideration between (1) goods or services initially sold and (2) any option to acquire additional goods or services. RD entities applying the cost accrual model to existing reward and loyalty programs would be required to amend their accounting policies in accordance with the above requirements. Sales Incentives RD entities often offer customers sales incentives and promotional programs, such as coupons, rebates, and free products (e.g., buy one, get one free ). These sales incentives may create variability in the pricing of the goods or services offered to the customer. Under the revised ED, if the transaction price is subject to variability, an entity would be required to use an estimated transaction price based on either (1) the expected value (i.e., a probability-weighted amount) or (2) the most likely amount (i.e., management s best estimate), depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled. However, the amount ultimately recognized as revenue shall not exceed the amount to which the entity is reasonably assured to be entitled.

8 US GAAP To use the expected-value technique, RD entities would need to estimate the transaction price in multiple scenarios. In making such estimates, entities would most likely have to use significant judgment; if there are material changes in estimates between reporting periods, financial statement volatility may result. The use of the most likely amount may be more predictive of the amount of consideration when there is a lack of information or a limited number of possible outcomes. However, in determining the most likely amount, RD entities would still need to exercise judgment and consider several key factors, such as the terms of the contract and the extent of their past experience with similar contracts. Contract Costs The revised ED requires capitalization of certain costs associated with obtaining a contract if those costs are incremental (e.g., sales commissions) and recoverable. In addition, the revised ED requires capitalization of certain costs of fulfilling a contract if all of the following criteria are met and the costs are not covered by other standards: 1. The costs relate directly to a contract (or a specific anticipated contract). 2. The costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future. 3. The costs are expected to be recovered. Examples of such costs include direct labour and materials, depreciation of equipment used in fulfilling the contract, and subcontractor costs. As a practical expedient, certain costs of obtaining a contract can be expensed as incurred when the amortization period is one year or less. Under the revised ED, capitalized contract costs should be amortized in a manner consistent with the pattern of transfer of the goods or services to which the asset relates and, in certain circumstances, may extend beyond the original contract term with the customer (e.g., when future anticipated contracts or expected renewal periods exist). The asset will be subject to impairment testing if any indicators of impairment exist. 08 Depending on how an entity currently accounts for revenue-related costs, the proposed guidance may result in significant changes in practice and potentially require RD entities to capitalize costs they may have previously expensed. Entities may want to closely evaluate the impact of the proposed guidance on their current accounting policies as well as whether they need to determine their accounting policy related to contract costs for short-term contracts with a duration of one year or less. Rights of Return To ensure customer satisfaction, RD entities often grant customers the right to return a product. In a manner consistent with current practice, the revised ED allows entities to recognize revenue for goods subject to a right of return (the entity s stand-ready obligation to accept returns is not deemed a separate performance obligation). However, the revised ED does require that an entity recognize separately in the statement of financial position both a refund liability (for the amount expected to be refunded to the customer) and an asset (for the entity s right to recover the product from the customer). The revised ED s guidance on accounting for a sale with a right of return is largely consistent with current practice under U.S. GAAP and IFRSs; however, entities will now be required to show on the balance sheet a liability for the refund obligation and an asset for the right to recover the product. In addition, entities will be required to subject the asset recognized to impairment testing if any indicators of impairment exist. Warranties RD entities often sell products with warranties assuring customers that the products will be free of defects at the time of sale and comply with agreed-upon specifications. In some cases, entities may also offer warranties that do more than simply assure the customer that a product complies with agreed-upon specifications (e.g., warranties that provide services for a fixed period after the initial warranty period has expired). RD entities often need to evaluate whether they are responsible for the warranty or whether the manufacturer or another third party has this responsibility. An RD entity that is not responsible for the warranty (e.g., a manufacturer s warranty) would not be required to apply the revised ED s guidance on warranties. However, if the RD entity s warranties offer protection beyond any initial warranty provided by the manufacturer, the guidance in the revised ED would apply. Under the revised ED, warranties would be accounted for as follows: 1. If a customer has the option to purchase a warranty separately from the entity, an entity should account for the promised warranty as a separate performance obligation and allocate a portion of the overall consideration to the warranty service. 2. If a customer does not have the option to purchase a warranty separately from the entity, the entity would use the cost accrual model to account for the warranty unless the warranty provides a service to the customer in addition to the assurance that the product complies with agreed-upon specifications (in which case the entity would account for the service as a separate performance obligation and revenue would be deferred). The revised ED will not change the accounting for most warranties (i.e., warranties assuring the customer that the good or service complies with agreed-upon specifications), which are generally accounted for under a cost accrual model. However, RD entities may want to reassess all warranties offered to ensure that the warranties are not providing any services beyond assuring the customer that the product complies with agreed-upon specifications. An entity will need to evaluate its accounting for warranties that provide more than assurance that a product complies with the agreed-upon specifications to determine whether a separate performance obligation is embedded in the warranty. In such circumstances, RD entities will need to gather the necessary information to allocate a portion of the transaction price to the separate performance obligation.

9 US GAAP An entity may need to further analyse warranties offering multiple services (or additional products) to determine each separate performance obligation. Example A department store sells a vacuum cleaner to a customer. The store offers the customer a standard manufacturer s warranty as well as the option to buy an additional one-year warranty that will protect the customer against any defects in the vacuum cleaner that arise during that period. In this example, the sale of the additional warranty would be deemed a separate performance obligation in accordance with the revised ED. Gift Cards Many RD entities give customers the right to make a non-refundable prepayment to the entity for the right or option to receive future goods or services (e.g., gift cards or gift certificates). The revised ED addresses how to recognize revenue for customers rights that are not expected to be exercised (e.g., breakage on gift cards sold to customers or layaway sales deposits that are forfeited). Specifically, the revised ED states that if an entity is reasonably assured to be entitled to the amount of expected breakage, the entity would recognize the effects of the expected breakage in proportion to the pattern of rights exercised by the customer. Otherwise, the expected breakage would be recognized when the likelihood of the customer exercising its remaining rights becomes remote. To recognize the effects of the expected breakage as revenue over time, an RD entity would need to have sufficient historical information to estimate the timing and amount of breakage so that it can determine whether the estimated amount of breakage is reasonably assured. If the entity cannot conclude that the estimated amount of breakage is reasonably assured, it will not be able to recognize the breakage as revenue until the likelihood of the customer s exercising its remaining rights becomes remote. An entity will also need to consider the unclaimed property laws that exist in the particular jurisdiction before determining that the likelihood is remote. Example An entity sells a $100 gift card that expires in two years and is reasonably assured, on the basis of historical experience with similar gift cards, that the amount of breakage is 10 percent, or $10. The customer purchases a product for $45 and uses its gift card. The entity may recognize revenue of $50 (revenue from transferring the product of $45+ breakage of $5 [$10 45/(100 10)]). If the entity cannot reasonably estimate the timing and amount of breakage on its gift cards, it would only recognize revenue for breakage when it becomes remote that the gift card will be redeemed. Shipping Terms International shipping terms such as FOB (free on board) or CIF (cost, insurance, freight) are often used in contracts with customers in which the sale of goods is subject to shipping. These terms are common in the RD industry and are instrumental in revenue recognition because they are the primary factors used to determine the point at which control and the inherent risks and rewards of the goods sold are transferred to the customer. In the RD industry, sellers commonly ship goods FOB shipping point but often enter into arrangements with their customers under which the seller continues to bear risk of loss or damage that is not covered by the carrier while the product is in transit. If damage or loss occurs under these circumstances, the seller is obligated to provide (or has a practice of providing) the buyer with replacement products at no additional cost. The seller may insure this risk with a third party or self-insure the risk. Such shipping terms are often called synthetic FOB destination shipping terms because the seller has retained the risk of loss or damage during transit. As a result, all risks and rewards of ownership have not been substantively transferred to the buyer and it would not be appropriate to recognize revenue before the goods are ultimately delivered to the buyer. Under the revised ED, instead of all revenue being deferred, such an arrangement may give rise to two performance obligations: (1) to provide the customer with a product and (2) to cover the risk of loss during transit. In this case, the transaction price would need to be allocated to each performance obligation and the satisfaction of each performance obligation would be separately assessed. In effect, this may mean that revenue allocated to the product could be recognized as soon as the product is shipped, while the revenue allocated to the obligation to cover losses would only be recognized once the goods arrive at the customer s destination. Other The revised ED would require significantly more extensive disclosures than current revenue standards, including quantitative and qualitative information about contracts and the significant judgments used in applying the guidance to those contracts. Entities should consider how detailed their disclosures need to be to meet the requirements and how much emphasis to place on each disclosure requirement The revised ED provides guidance on many other topics that were not addressed above, including the identification and satisfaction of performance obligations, customer acceptance (e.g., if an entity delivers a product to a customer for a trial period and the customer is not committed to pay any consideration until the trial period lapses), principal-versus-agent considerations, sell-through arrangements, consignment arrangements, bill-and-hold arrangements, collectability, and onerous contracts. RD entities should carefully analyse the revised ED s guidance on these important topics to determine the significance to their financial reporting. Challenges for RD Entities Increased Use of Judgment Management will need to exercise significant judgment in applying certain of the revised ED s requirements, including those related to the identification of performance obligations and allocation of revenue to each performance obligation. It is important for entities to consider how the revised ED specifically applies to them so that they can prepare for any changes in revenue recognition patterns. 09

10 US GAAP Retrospective Application The revised ED proposes retrospective application, with certain optional practical expedients available to entities at their discretion. This aspect of the proposal may require RD entities to gather data and assess contracts that commenced several years before the revised ED s effective date. RD entities also will most likely be required to perform dual tracking of revenue balances during this retrospective period, given the potential difficulty associated with retroactively recalculating revenue balances at the time the new standard becomes effective. Systems, Processes, and Controls The revised ED proposes several new practices and disclosure requirements under which RD entities will have to gather and track information that they may not have previously monitored. The systems and processes associated with such information may need to be modified to support the capture of additional data elements that may not currently be supported by legacy systems. RD entities with large volumes of sales deals may find it operationally challenging to assess each sales deal to categorize and account for customer incentives in accordance with the revised ED; such entities may need to make substantial system modifications to facilitate this process. Further, to recognize revenue associated with breakage, RD entities would also need to have sufficient historical information to predict whether they are reasonably assured to be entitled to the revenue. To capture such data in sufficient detail, RD entities may need to make system and process modifications. RD entities may also recognize an asset for certain costs of obtaining or fulfilling a contract (unless the amortization period is one year or less and entities choose to recognize those costs as expenses immediately). Such entities may need to modify their current accounting practices and make appropriate system modifications to track data on contract duration, contract costs, and periodic amortization and impairment testing of capitalized costs. Further, to ensure the effectiveness of internal controls over financial reporting, management will need to assess whether additional controls need to be implemented. RD entities may also need to begin aggregating essential data from new and existing contracts since many of these contracts will most likely be subject to the proposed rules. Note that this section gives only a few examples of possible changes RD entities may need to make to their systems, processes, and controls; such entities should evaluate all aspects of the revised ED s requirements to determine whether any other modifications may be necessary. Thinking Ahead A final standard is not expected to be issued until the first quarter of 2013 and would be effective no earlier than for annual periods beginning on or after January 1, 2015 (with a minimum of a oneyear deferral for non-public entities applying U.S. GAAP). RD entities should take advantage of this time to carefully examine the revised ED and begin assessing the impact it may have on their current accounting policies, procedures, systems, and processes. 10

11 If you have any questions regarding any of the articles in this publication, please contact one of the following audit experts: Czech Accounting Stanislav Staněk: Michal Brandejs: IFRS and US GAAP Martin Tesař: Soňa Plachá: Gabriela Jindřišková: Deloitte Advisory s.r.o. Nile House Karolinská 654/ Prague 8 - Karlín Czech Republic Tel.: Fax: This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, any of its member firms or any of the foregoing s affiliates (collectively the Deloitte Network ) are, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your finances or your business. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication. *** Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and deep local expertise to help clients succeed wherever they operate. Deloitte's approximately 170,000 professionals are committed to becoming the standard of excellence Deloitte Czech Republic