Tools, practice aids and publications» In depth and Practical guides Revenue from contracts with customers: PwC In depth INT

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1 Tools, practice aids and publications» In depth and Practical guides Revenue from contracts with customers: PwC In depth INT Revenue from contracts with Publication date: 01 Jun 2016 This publication (pdf, 301kb) summarises the new revenue recognition model. The boards have established a joint Transition Resource Group (TRG) to aid entities transitioning to the new standard. We encourage entities to use this document as a guideline and monitor developments discussed by the TRG and the boards during the transition period. The following supplements are available: Engineering and construction industry supplement (pdf, 277kb). Industrial products and manufacturing industry supplement (pdf, 245kb). Pharmaceutical and life sciences industry supplement (pdf, 311kb). Communications industry supplement (pdf, 260kb). Automotive industry supplement (pdf, 206kb). Entertainment and media industry supplement (pdf, 207kb). Aerospace and defence industry supplement (pdf, 267kb). Technology industry supplement (pdf, 234kb). Retail and consumer industry supplement (revised September 2014) (pdf, 254kb). Asset management industry supplement (pdf, 212kb). Power and utilities industry supplement (pdf, 251kb). Mining industry supplement (pdf, 205kb). Insurance intermediaries industry supplement (pdf, 178kb). Oil and gas industry supplement (pdf, 161kb). Transportation and logistics industry supplement (pdf, 137kb). Insurance entity industry supplement (pdf, 189kb) The following industry supplement webcasts are also available: Engineering and construction industry Pharmaceutical and life sciences Communications industry Aerospace and defence industry Entertainment and media industry Retail and consumer industry Technology industry At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in These materials were downloaded from Inform ( under licence.page 1 / 307

2 required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. Entities will need to consider changes that might be necessary to information technology systems, processes, and internal controls to capture new data and address changes in financial reporting. Background.1 The objective of the revenue standard (IFRS 15 and ASC 606) is to provide a single, comprehensive revenue recognition model for all contracts with customers to improve comparability within industries, across industries, and across capital markets..2 The revenue standard contains principles that an entity will apply to determine the measurement of revenue and timing of when it is recognised. The underlying principle is that an entity will recognise revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services..3 The revenue standard is effective for entities that report under IFRS for annual periods beginning on or after 1 January Early adoption is permitted for IFRS reporters. The revenue standard is effective for the first interim period within annual reporting periods beginning after 15 December 2016 for US GAAP public reporting entities and early adoption is not permitted. It will be effective for annual reporting periods beginning after 15 December 2017 and interim periods within annual periods beginning after 15 December 2018 for US GAAP nonpublic entities. Earlier application is permitted for non-public entities; however, adoption can be no earlier than periods beginning after 15 December This In depth summarises the new revenue recognition model. The boards have established a joint Transition Resource Group (TRG) to aid entities transitioning to the new standard. We encourage entities to use this document as a guideline and monitor developments discussed by the TRG and the boards during the transition period. Key provisions Scope.5 The revenue standard applies to all contracts with customers, except for: lease contracts; insurance contracts; financial instruments and certain contractual rights or obligations within the scope of other standards; non-monetary exchanges between entities in the same line of business to facilitate sales to customers; and certain guarantees within the scope of other standards (other than product or service warranties)..6 Revenue from a transaction or event that does not arise from a contract with a customer is not within the scope of the revenue standard and should continue to be accounted for in accordance with other standards. Such transactions or events include, but are not limited to: dividends; non-exchange transactions; changes in the fair value of biological assets, investment properties and the inventory of broker-traders (IFRS only); and changes in regulatory assets and liabilities arising from alternative revenue programs for rate-regulated activities in the scope of the guidance on regulated operations (US GAAP only)..7 Some contracts include components that are in the scope of the revenue standard and other components that are in the scope of other standards (for example, a contract that includes both These materials were downloaded from Inform ( under licence.page 2 / 307

3 a lease and maintenance services). An entity will apply the separation and/or measurement guidance in other standards first and then apply the guidance in the revenue standard. An entity will apply the revenue standard to separate and/or measure the components of the contract if other standards do not include separation or measurement guidance..8 The revenue standard applies to all contracts with customers. A customer is a party that contracts with an entity to obtain goods or services that are the output of that entity s ordinary activities. The scope includes transactions with collaborators or partners if the collaborator or partner obtains goods or services that are the output of the entity s ordinary activities. It excludes these types of arrangements, however, if the parties are participating in an activity together where they share the risks and benefits of that activity. PwC observation: Management will need to evaluate arrangements with collaborators and partners to identify whether such arrangements or portions thereof are in the scope of the revenue standard. Arrangements where parties share risks and benefits are different from those where one entity obtains goods or services from the other. For example, a biotechnology entity that has an agreement with a pharmaceutical entity to share equally in the development of a specific drug candidate is unlikely to be in the scope of the standard because the parties share the risks and benefits in developing the drug. The arrangement is likely to be in scope if the substance of the arrangement is that the biotechnology entity sells its compound to the pharmaceutical entity and/or provides research and development services. Management will also need to evaluate whether the arrangement contains elements of both a collaboration and a sale to a customer..9 The revenue standard generally applies to an individual contract with a customer. The revenue standard can be applied to a portfolio of contracts or performance obligations if the entity reasonably expects that the effect of applying a portfolio approach would not differ materially from considering each contract or performance obligation separately. Some entities enter into contracts with a large number of customers, all of which have the same or similar terms and conditions. It is appropriate in these situations to consider whether the revenue standard could be applied to a portfolio of contracts or performance obligations. The five-step approach.10 Entities will follow a five-step approach to apply the standard: Step 1: Identify the contract(s) with the customer Step 2: Identify the separate performance obligations in the contract Step 3: Determine the transaction price Step 4: Allocate the transaction price to separate performance obligations Step 5: Recognise revenue when (or as) each performance obligation is satisfied Step 1: Identify the contract(s) with the customer.11 A contract is an agreement between parties that creates enforceable rights and obligations. It can be written, oral, or implied by an entity s customary business practice. Generally, any agreement that creates enforceable rights and obligations will meet the definition of a contract. An entity will apply the revenue standard to each contract with a customer when all of the following criteria are met: These materials were downloaded from Inform ( under licence.page 3 / 307

4 The parties have approved the contract and intend to perform their respective obligations. Each party s rights regarding the goods or services to be transferred can be identified. The payment terms can be identified. The risk, timing, or amount of the entity s future cash flows are expected to change (that is, the contract has commercial substance). It is probable that the entity will collect the consideration to which it will be entitled in exchange for goods or services transferred..12 An entity will reassess whether the criteria are met each reporting period to determine if the criteria are subsequently met if they are not met at contract inception. An entity that receives consideration from the customer when the criteria are not met will not recognise revenue until either: the entity has no remaining performance obligations and substantially all the consideration is received and non-refundable, or the contract is terminated and amounts received are non-refundable. Collectability.13 An entity will assess at the inception of the contract whether it is probable it will collect the transaction price (see paragraph 29). This assessment determines whether a contract exists for the purpose of applying the revenue standard..14 The collectability assessment is based on the customer s ability and intent to pay as amounts become due, after considering any price concessions the entity expects to provide. An entity will consider credit risk, but not other uncertainties, such as those related to performance or measurement, as these are accounted for separately as part of determining the measurement and timing of revenue..15 Credit losses arising from a contract that was probable of collection at inception will be recognised as an expense in the income statement. This expense will be measured in accordance with the relevant financial instrument standards. An entity will only reassess whether it is probable it will receive payment (and thus, whether a contract exists for the purpose of applying the revenue guidance) if there is an indication of a significant change in facts and circumstances, such as a significant deterioration in a customer s ability to pay for the remaining goods and services. PwC observation: The term probable is defined differently in IFRS and US GAAP. Though different thresholds were created, in most cases an entity will not enter into a contract with a customer when there is significant credit risk without also having adequate economic protection. Judgement is required to determine the accounting when there is a significant deterioration in a customer s ability to pay after the inception of an arrangement. Management will have to assess whether the deterioration relates to performance obligations previously satisfied, performance obligation to be performed in the future, or both. Contract combination.16 Contracts will be combined and accounted for as a single contract only if they are entered into at or near the same time, with the same customer (or related parties), and one or more of the following criteria are met: These materials were downloaded from Inform ( under licence.page 4 / 307

5 The contracts achieve a single commercial objective and are negotiated as a package. The price or performance of one contract influences the amount of consideration to be paid in the other contract. The goods or services in the separate contracts represent a single performance obligation. Contract modifications.17 A contract modification occurs when the parties approve a change that either creates new or changes existing enforceable rights and obligations. Approval can be in writing, oral, or implied by customary business practice. Management will need to determine when a modification, such as a claim or unpriced change order, is approved and therefore creates enforceable rights and obligations. An entity will not account for a modification until it is approved; that is, it will continue to apply the revenue standard to the existing contract..18 A contract modification is treated as a separate contract if the modification adds one or more distinct performance obligations to the contract and the price increases by an amount that reflects the stand-alone selling price of the additional distinct performance obligation(s). Otherwise, a modification is accounted for as an adjustment to the original contract, either prospectively or through a cumulative catch-up adjustment depending on whether the remaining goods or services in the contract are distinct..19 An entity will account for a modification prospectively if the goods or services in the modification are distinct from those transferred before the modification. The remaining consideration in the original contract not yet recognised as revenue is combined with the additional consideration promised in the modification to create a new transaction price that is then allocated to all remaining performance obligations (that is, both those not yet completed in the original contract and those added through the modification). This effectively accounts for the modification as a termination of the original contract and the inception of a new contract for all performance obligations that remain unperformed..20 An entity will account for a modification through a cumulative catch-up adjustment if the goods or services in the modification are not distinct from those in the original contract and are thus part of a single performance obligation that is only partially satisfied. The measure of progress towards satisfying the performance obligation is updated to reflect performance completed and performance that remains..21 A change to only the transaction price will be treated like any other contract modification. The change in price will be either accounted for prospectively or on a cumulative catch-up basis, depending on whether the remaining performance obligations are distinct. PwC observation: Accounting guidance for contract modifications did not previously exist for most industries and arrangements. The new guidance therefore provides structure in an area where practice was previously mixed. Management will need to apply judgement when evaluating whether goods or services in a modification are distinct, and whether the price reflects the stand-alone selling price to determine the accounting. This might be more challenging in situations where there are multiple performance obligations in a contract, or when modifications occur frequently. Step 2: Identify the separate performance obligations in the contract.22 A performance obligation is a promise to transfer a distinct good or service (or a series of distinct goods or services that are substantially the same and have the same pattern of transfer) These materials were downloaded from Inform ( under licence.page 5 / 307

6 to a customer. The promise can be explicit, implicit, or implied by an entity s customary business practice. The objective of identifying distinct performance obligations is to depict the transfer of goods or services to the customer. Identifying performance obligations is more challenging when there are multiple explicit or implicit promises in a contract..23 Explicit and implicit promises in a contract to provide goods or services, including promises to provide goods or services that a customer can resell or provide to its customer (an end customer ), are performance obligations, even if they are satisfied by another party..24 Management will need to determine whether promises are distinct when there are multiple promises in a contract. This is important because distinct performance obligations are the units of account that determine when and how revenue is recognised..25 A good or service is distinct only if: the customer can benefit from the good or service either on its own or together with other readily available resources (that is, the goods or services are capable of being distinct); and the good or service is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract)..26 A customer can benefit from a good or service on its own if it can be used, consumed, or sold to generate economic benefits. A good or service that cannot be used on its own, but can be used with readily available resources, is still distinct, as the entity has the ability to benefit from it. A readily available resource is one that is sold by the entity, by others in the market, or that a customer has already obtained from the entity..27 Determining whether a good or service is distinct within the context of the contract requires assessment of the contract terms and the intent of the parties. Indicators include, but are not limited to: The entity does not provide a significant service of integrating the individual goods or services in the contract into a bundle that is the combined item the customer has contracted to receive. The good or service does not customise or significantly modify another contractually promised good or service. The good or service is not highly dependent on or highly interrelated with other goods or services in the contract; therefore, a customer s decision to not purchase a good or service does not significantly affect the other promised goods or services in the contract. PwC observation: The revenue standard provides indicators rather than criteria to determine when a good or service is distinct within the context of the contract. This allows management to apply judgement to determine the separate performance obligations that best reflect the economic substance of a transaction. All promises in an arrangement should be identified. Promises that are inconsequential or perfunctory need to be identified, even if they are not the main deliverable in the arrangement, because all promises in a contract are goods or services that a customer expects to receive. An entity should assess whether inconsequential or perfunctory performance obligations are immaterial to the financial statements..28 Goods or services that are not distinct should be combined with other goods or services until These materials were downloaded from Inform ( under licence.page 6 / 307

7 the entity identifies a bundle of goods or services that is distinct. Step 3: Determine the transaction price.29 The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of a third party (for example, some sales taxes). Determining the transaction price is more complex if the arrangement involves variable consideration, a significant financing component, non-cash consideration, or consideration payable to a customer. Variable consideration and the constraint on revenue recognition.30 The transaction price might include an element of consideration that is variable or contingent on the outcome of future events, including (but not limited to) discounts, refunds, rebates, credits, incentives, performance bonuses, and royalties. Consideration can also vary if an entity s ability to retain a fixed amount of consideration is contingent upon a future event. An entity s practices, policies, or statements might also result in variable consideration, for example, if they indicate the entity will provide price concessions..31 Variable consideration should be estimated using the more predicative of the following approaches: the expected value or the most likely amount. The expected value approach represents the sum of probability-weighted amounts for various possible outcomes. The most likely amount represents the most likely amount in a range of possible amounts. The approach used is not a policy choice. Management should use the approach that it expects will best predict the amount of consideration to which the entity will be entitled based on the terms of the contract and taking into account all reasonably available information. The approach used should also be applied consistently throughout the contract..32 Variable consideration included in the transaction price is subject to a constraint. An entity should recognise revenue as performance obligations are satisfied only if it is highly probable (IFRS) or probable (US GAAP) that a change in the estimate of the variable consideration would not result in a significant reversal of the cumulative revenue recognised. This assessment will often require judgement..33 The following indicators suggest that including an estimate of variable consideration in the transaction price could result in a significant reversal of cumulative revenue: The amount of consideration is highly susceptible to factors outside the entity s influence. Resolution of the uncertainty about the amount of consideration is not expected for a long period of time. The entity has limited experience with similar types of contracts. The entity has a practice of offering a broad range of price concessions or changing payment terms and conditions in similar circumstances for similar contracts. There is a large number and broad range of possible outcomes..34 Management will need to determine if there is a portion of the variable consideration (that is, some minimum amount) that should be included in the transaction price, even if the entire estimate of variable consideration is not included due to the constraint. Management s estimate of the transaction price will be reassessed each reporting period, including any estimated minimum amount of variable consideration..35 The constraint also applies to contracts with a fixed price if it is uncertain whether the entity will be entitled to all of the consideration even after the performance obligation is satisfied. One example is an entity that enters into a contract with a customer to provide legal services in return for a fixed fee, but the entity will only be paid if the court rules in favour of the customer. The These materials were downloaded from Inform ( under licence.page 7 / 307

8 entity might not be able to recognise revenue until the court rules on the case, even though the legal services have been provided. However, if management considers it highly probable (IFRS) or probable (US GAAP) that the fee is not subject to significant reversal of cumulative revenue, the entity will recognise revenue prior to the court s ruling..36 Performance-based incentive fees (for example, fees that vary based on the achievement of a contract milestone or an investment portfolio s performance) are also variable consideration and therefore subject to the constraint. PwC observation: The reach of the variable consideration guidance introduced in the revenue standard is broad and includes amounts that historically might not have been viewed as variable consideration. For example, fixed amounts that an entity is entitled to only upon the achievement of certain events are variable consideration under the revenue standard and included in the transaction price subject to the constraint. Management will need to think broadly about amounts, whether fixed or variable, that will be accounted for as variable consideration. The evaluation of variable consideration will require judgement in many cases. Entities that defer revenue recognition under current guidance because the price is not reliably measurable (IFRS) or fixed or determinable (US GAAP) could be significantly affected by the new standard. An example is a situation where the price is fixed, but the entity has a history of granting concessions. Entities could be required to recognise some minimum amount of revenue when control transfers as opposed to waiting until the extent of price concessions is resolved. This is because it is unlikely that an entity would be willing to grant a concession for 100% of the price. New processes might be needed for making and monitoring estimates of variable consideration on an ongoing basis. Concurrent documentation of the judgements considered in making estimates will also be important..37 The standard includes a narrow exception to the constraint on variable consideration for sales- or usage-based royalties on licences of intellectual property (IP). Royalties from licences of IP are not included in the transaction price until they are no longer variable (that is, when the customer s subsequent sales or usage occur). The exception is limited to sales- or usage-based licences of IP and will not apply to other royalty arrangements, and should not be applied by analogy. PwC observation: Management will need to apply judgement to determine whether an arrangement qualifies for the exception to the overall variable consideration constraint, given that neither intellectual property nor royalty are defined in IFRS or US GAAP. The boundaries for determining when the sales- and usage-based exception applies might be an area of the new standard that is subject to further clarification. An outright sale of IP, for example, does not appear to qualify for the exception. It is unclear whether a perpetual licence, which is typically viewed as an in-substance sale, will qualify for the exception. The exception also does not appear to apply if the licence is not distinct from other promised goods or services in an arrangement. Even if the licence is distinct, it appears that the entity will need to conclude that the contingent consideration (that is, the sales- or usage-based royalty) relates specifically to the licence and not to other performance obligations in the arrangement for the exception to apply. Certain fixed payments might be in-substance sales-based royalties and therefore subject to the exception. An example is an arrangement that requires a licensee to make a fixed payment that is subject to claw back if the licensee does not meet certain sales or usage targets. These materials were downloaded from Inform ( under licence.page 8 / 307

9 Significant financing component.38 The transaction price should be adjusted for any significant financing component in the arrangement. A practical expedient allows entities to disregard the time value of money if the period between transfer of the goods or services and payment is less than one year, even if the contract itself is for more than one year. In assessing whether a contract contains a significant financing component, an entity should consider various factors, including: the length of time between when the entity transfers the goods or services to the customer and when the customer pays for them; whether the amount of consideration would substantially differ if the customer paid cash when the goods or services were transferred; and the interest rate in the contract and prevailing interest rates in the relevant market..39 An entity that is paid in advance for goods or services need not reflect the effects of the time value of money when the timing of transfer of those goods or services is at the customer s discretion. For example, if a customer purchases a prepaid phone card from a telecom entity and uses the prepaid airtime at its discretion, the time value of money need not be considered. Another example is a customer loyalty program where the customer can redeem the points awarded by the entity at its discretion. Those entities will not be required to account for time value of money even though there could be a significant timing difference between payment and performance..40 There are two additional situations in which a significant financing component is not present. The first is when a substantial amount of the promised consideration is variable and the amount, or amount and timing, of payment varies due to factors outside the control of the entity or customer (for example, a sales-based royalty). The other is when the difference between the contractual consideration and the cash selling price arises for reasons other than the granting of finance to the entity or the customer (for example, protection against non-performance). The second situation allows entities to consider the intent of the parties when assessing whether a significant financing component is present..41 The amount of revenue recognised will be different from the amount of cash received from the customer when an arrangement contains a significant financing component. Revenue recognised will be less than cash received when payments are made after performance, because the entity is providing the customer with financing. A portion of the consideration will be recognised as interest income. Revenue recognised will exceed the cash received for payments made in advance of performance, because the entity receives financing from the customer. The entity will recognise interest expense on the financing related to advance payments..42 An entity needs to determine the discount rate to use when calculating the interest element of a significant financing component. The entity should use a discount rate that reflects what it would charge in a separate financing transaction with the customer, including consideration of any collateral or guarantees it would require. An entity receiving a significant financing benefit (for example, because it received an advance payment) should consider its incremental borrowing rate to determine the interest rate. The discount rate is not reassessed after inception of the contract. PwC observation: Management will need to evaluate arrangements with customers to determine whether they include a significant financing component. The guidance related to a significant financing component is different than current guidance related to applying the time value of money. These materials were downloaded from Inform ( under licence.page 9 / 307

10 In some cases it will be clear that a significant financing component exists due to the terms of the arrangement. In other cases it could be challenging to determine whether a significant financing component exists, especially in some long-term arrangements with multiple performance obligations if goods or services are delivered and cash payments received throughout the arrangement. The standard allows for some level of judgement by requiring entities to assess whether the substance of the payment arrangement is a financing. For example, a software entity agrees to provide three years of post-contract customer support (PCS) for C600, which the customer pays upfront and can renew for C200 annually after the initial three-year period. The entity will need to consider whether there is a significant financing component because the customer paid C600 in advance, but there is no discount for paying upfront as compared to the annual pricing (C200 per year). If the advance payment is required for reasons other than obtaining financing, such as for business purposes to obtain a longerterm contract, then the entity would conclude that a significant financing obligation does not exist. An entity with contracts that include a significant financing component should consider any operational challenges relating to measuring and tracking the interest element of the arrangement. This could require additional information technology systems, processes, or internal controls to capture and measure such information. Non-cash consideration.43 An entity will measure any non-cash consideration exchanged in the transaction (including equity of the customer) at its fair value to determine the transaction price. An entity will measure the consideration indirectly by reference to the stand-alone selling price of the goods or services promised in the arrangement if it cannot reasonably estimate the fair value of the non-cash consideration..44 An entity could have a customer that contributes goods or services (for example, materials or labour) to facilitate the fulfilment of a contract. The entity will need to assess whether it obtains control of those contributed goods or services to determine whether they are non-cash consideration and therefore revenue to the entity. Consideration payable to a customer.45 Consideration paid (or expected to be paid) to a customer or to a customer s customer reduces the transaction price unless the payment is made in exchange for a distinct good or service that the customer transfers to the entity. The definition of distinct is consistent with the guidance in step 2 for identifying performance obligations (see paragraph 25). An entity will recognise the reduction of revenue in the later of: the period the entity recognises revenue for the transfer of the promised goods or services; or the period the entity pays or promises to pay the consideration (even if the payment is conditional on a future event)..46 Consideration paid or payable to a customer (or to other parties that purchase the entity s goods or services from the customer) includes cash, credits, or other items that can be applied to amounts owed to the entity. For example, a coupon or voucher that an end customer can redeem to reduce the purchase price of the entity s goods sold through a distributor is consideration payable to a customer..47 Consideration that is a payment for a distinct good or service is accounted for consistently with how an entity accounts for other purchases from suppliers. If the consideration paid for These materials were downloaded from Inform ( under licence.page 10 / 307

11 distinct goods or services is above the fair value of those goods or services, any excess is recorded as a reduction of the transaction price. Step 4: Allocate the transaction price to separate performance obligations.48 The transaction price is allocated to the separate performance obligations in a contract based on the relative stand-alone selling prices of the goods or services promised. This allocation is made at contract inception and not adjusted to reflect subsequent changes in the stand-alone selling prices of those goods or services..49 The best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately. Management will need to estimate the selling price of goods or services that do not have an observable stand-alone selling price, and should maximise the use of observable inputs when making that estimate. Possible estimation methods include, but are not limited to: expected cost plus an appropriate margin; assessment of market prices for similar goods or services adjusted for entityspecific costs and margins; and residual approach, in limited circumstances. PwC observation: The revenue standard requires entities to allocate the transaction price to each separate performance obligation. Under current guidance, entities generally allocate the consideration to individual components or deliverables in an arrangement. Under US GAAP, the amount of revenue allocated to the delivered component(s) is limited to the non-contingent amount. The revenue standard does not include a requirement to limit the amount of the transaction price allocated to a delivered component to the non-contingent amount. Residual approach.50 A residual approach can only be used to calculate the stand-alone selling price of a distinct good or service if the selling price is highly variable or uncertain. It can be applied regardless of whether that good or service is delivered at the beginning or at the end of the contract..51 A selling price is highly variable when an entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when an entity has not yet established a price for a good or service and it has not been sold previously..52 The residual approach requires that an entity first determine if any discounts need to be allocated to specific performance obligations in accordance with the guidance in paragraph 53 prior to using the residual approach to determine the stand-alone selling price of the remaining item(s). If the discount is not allocated to specific performance obligations, management will allocate the discount proportionately to all performance obligations in the contract. When a residual approach is used, judgement will be needed to determine if the amount allocated to the item faithfully depicts the amount of consideration to which the entity expects to be entitled. The residual approach cannot be used, for example, if it results in a very low amount or no consideration allocated to an item. PwC observation: The residual approach is different from the residual method that is used by some entities today (for example, software companies). Applying today s residual method results in the entire These materials were downloaded from Inform ( under licence.page 11 / 307

12 discount in an arrangement being allocated to the first item delivered under the contract. This will not be the case under the new guidance because discounts will typically be allocated proportionately to all items. Use of the residual approach should be limited and it will be used less frequently than the residual method is used today. An entity that applies the residual method today should not presume it will be able to use a residual approach to estimate selling price under the new standard, and should not expect the residual method and the residual approach to have identical results. Allocating discounts and variable consideration.53 Discounts and variable consideration will typically be allocated proportionately to all of the performance obligations in the contract. If certain conditions are met, a discount or variable consideration can be allocated to one or more separate performance obligations, rather than to all performance obligations in the arrangement..54 An entity should allocate a discount entirely to one or more performance obligation(s) if all of the following criteria are met: The entity regularly sells each distinct good or service (or each bundle of distinct goods or services) on a stand-alone basis. The entity regularly sells, on a stand-alone basis, a bundle of some of those goods or services at a discount to the stand-alone selling prices of the goods or services in that bundle. The discount attributable to the bundle of goods or services is substantially the same as the discount in the contract. PwC observation: An arrangement will need to include at least three performance obligations to apply this guidance, as the entity will need to regularly sell at least two performance obligations together to evidence that a subset of the arrangement is separately sold at the discount. The revenue standard includes multiple examples to illustrate how an entity will allocate discounts and variable consideration..55 Changes in the estimate of variable consideration should be allocated entirely to a performance obligation, or to a distinct good or service that forms part of a single performance obligation, if both of the following criteria are met: The variable payment relates to a specific performance obligation or outcome from satisfying that performance obligation. Allocating the variable amount of the consideration entirely to the separate performance obligation is consistent with the amount of consideration that the entity expects to be entitled to for satisfying that performance obligation after considering all other performance obligations and payment terms in the contract. Step 5: Recognise revenue when (or as) each performance obligation is satisfied.56 The final step in the model is recognising revenue. An entity will recognise revenue when (or as) a good or service is transferred to the customer and the customer obtains control of that good or service. Control of an asset refers to an entity s ability to direct the use of and obtain These materials were downloaded from Inform ( under licence.page 12 / 307

13 substantially all of the remaining benefits (that is, the potential cash inflows or savings in outflows) from the asset. Directing use of an asset refers to a customer s right to deploy that asset, to allow another entity to deploy that asset in its activities, or to restrict another entity from deploying that asset. PwC observation: The standard requires management to determine when control of a good or service has transferred to the customer. The timing of revenue recognition could change for some transactions compared to current guidance, which is more focused on the transfer of risks and rewards. The transfer of risks and rewards is an indicator of whether control has transferred, but additional indicators will also need to be considered. For example, an entity that transfers control of a good to a customer but retains some economic risks might need to record revenue when the good transfers, while under existing guidance revenue recognition might be delayed until all of the economic risks have also transferred..57 An entity should determine at contract inception whether control of a good or service is transferred over time or at a point in time. This determination should depict the transfer of benefits to the customer and should be evaluated from the customer s perspective. An entity should first assess whether the performance obligation is satisfied over time. If not, the good or service transfers at a point in time. Performance obligations satisfied over time.58 An entity will recognise revenue over time if any of the following criteria are met: The customer concurrently receives and consumes the benefits provided by the entity s performance as the entity performs. The entity s performance creates or enhances a customer-controlled asset. The entity s performance does not create an asset with an alternative use and the entity has a right to payment for performance completed to date..59 The first criterion generally addresses service contracts where no asset is created and the customer consumes the services as they are provided. The performance obligation is satisfied over time if another entity would not have to substantially re-perform the work completed to date to fulfil the remaining obligation to the customer. For example, a contract with a customer to provide daily cleaning services of an office building would meet this criterion. Contractual or practical limitations that prevent an entity from transferring a remaining performance obligation to another entity are not considered in this evaluation..60 The second criterion addresses transactions where an asset is created or enhanced and the customer controls that asset as it is created. This applies in situations where the customer controls the work-in-progress as the entity manufactures goods. For example, it is common in transactions with a government that the government entity (the customer) controls any work-inprogress or other output of the contract. Management should apply the guidance on transfer of control to determine whether the customer obtains control of the asset as it is created..61 The last criterion addresses situations where the customer does not control an asset as it is created, or no asset is created by the entity s performance. Management will need to consider whether the asset being created has an alternative use to the entity (if an asset is created) and whether the entity has an enforceable right to payment for performance to date..62 The assessment of whether an asset has an alternative use should be made at contract inception, and not reassessed. Management should consider its ability to redirect a product that is partially completed to another customer, considering both contractual and practical limitations. These materials were downloaded from Inform ( under licence.page 13 / 307

14 A substantive contractual restriction that limits management s ability to redirect the asset could indicate the asset has no alternative use. Practical limitations, such as significant costs required to rework the asset so it could be directed to another customer, could also indicate that the asset has no alternative use..63 A right to payment exists if an entity is entitled to payment for performance completed to date if the customer terminates the contract for reasons other than the entity s non-performance. A specified payment schedule does not, by itself, indicate the entity has a right to payment for performance to date. The assessment of the enforceability of the right to payment should include consideration of the contract terms and any legal precedent that could override the contract terms..64 The right to payment should compensate the entity at an amount that reflects the selling price of the goods or services provided to date, rather than provide compensation for only costs incurred to date or the entity s potential loss of profit if the contract is terminated. This would be an amount that covers an entity s cost plus a reasonable profit margin for work completed. PwC observation: Management will need to apply judgement to assess the criteria for performance obligations satisfied over time, especially when assessing whether assets have an alternative use and whether the entity has a right to payment for performance completed to date. For example, management will need to assess whether there is a substantive reason for restrictions on transfer of the asset(s) to another party in a contract to determine whether assets have an alternative use. Manufacturers of large volumes of homogeneous goods produced to a customer s specification might be surprised to find that they could meet the criteria for performance obligations satisfied over time. This is because (1) such goods often have no alternative use to the entity given their customisation or contractual restrictions, and (2) the payment terms in these arrangements might include a protective clause that provides for payment for performance to date in the event the contract is cancelled. Entities that manufacture these types of goods could be required to recognise revenue as the goods are produced, rather than when they are delivered to the customer. Differences in payment terms could result in the goods being treated as a performance obligation satisfied over time in one case and as inventory transferred at a point in time in another. The right to payment criterion might not be satisfied if the customer only provides reimbursement for the cost of units in production. Performance obligations satisfied at a point in time.65 An entity will recognise revenue at a point in time (when control transfers) for performance obligations that do not meet the criteria for recognition of revenue over time..66 To determine when a customer obtains control and an entity satisfies a performance obligation, the entity should consider the definition of transfer of control in paragraph 56 and the following indicators: The entity has a present right to payment for the asset. The entity transferred legal title to the asset. The entity transferred physical possession of the asset. The entity transferred the significant risk and rewards of ownership to the customer. The customer accepted the asset. These materials were downloaded from Inform ( under licence.page 14 / 307

15 PwC observation: All of the indicators above do not need to be satisfied for revenue to be recognised at a point in time. The standard does not place more weight on one indicator over another. An entity will need to consider all indicators, not just whether significant risk and rewards have transferred, to determine when revenue should be recognised. Measuring progress toward satisfying a performance obligation.67 For a performance obligation satisfied over time, the objective is to recognise revenue in a manner that depicts the transfer of control of the promised goods or services to the customer. Methods for measuring progress include: output methods, such as units produced or delivered, contract milestones, or surveys of work performed; and input methods, such as costs incurred, labour hours expended, time elapsed, or machine hours used..68 Entities using an input method to measure progress should exclude the effects of inputs that do not depict the transfer of control to the customer. An entity sometimes receives materials that a customer controls prior to when those materials are used in the good or service the entity is providing (uninstalled materials). An entity might also incur costs that are attributable to significant inefficiencies in the entity s performance that were not considered in determining the contract price. These situations can create challenges if an entity is using an input method to measure progress. The measure of progress should be adjusted to ensure that it depicts the entity s performance. The standard includes an example that illustrates how management will recognise revenue when significant materials are delivered prior to installation..69 Revenue should only be recognised for a performance obligation satisfied over time if the entity can reasonably measure its progress toward complete satisfaction. An entity must have reliable information that can be applied to an appropriate method of measuring progress to meet this objective. An entity that cannot reasonably measure the outcome of a performance obligation, but expects to recover the costs incurred, should recognise revenue only to the extent of the costs until a reliable measure of progress can be made. Other considerations.70 Several issues exist beyond applying the five steps of the model. The revenue standard provides guidance in the following areas to assist entities in applying the model. Licences.71 A licence establishes a customer s rights related to an entity s IP and the entity s obligations related to those rights. Licences of IP include, among others: software and technology rights; media and entertainment rights; franchises; patents; trademarks; and copyrights. Licences can vary significantly and include different features and economic characteristics, which can lead to significant differences in the rights provided..72 An entity should first consider the guidance for distinct performance obligations to determine if a licence is distinct from other goods or services in an arrangement. An entity will combine licences that are not distinct with other goods and services in the contract and recognise revenue when it satisfies the combined performance obligation. Examples of licences that are These materials were downloaded from Inform ( under licence.page 15 / 307

16 not distinct include a licence that is integral to the functionality of a tangible good (such as software included on a hardware device) or a licence that the customer can benefit from only in conjunction with a related service (such as access to online internet content)..73 The nature of the rights provided in some licence arrangements is to allow access to the entity s IP as it exists throughout the licence period. Licences that provide access are performance obligations satisfied over time and, therefore, revenue is recognised over time. The nature of the rights in other transactions is to provide a right to use the entity s IP as it exists at the point in time the licence is granted. Licences that provide a right to use an entity s IP are performance obligations satisfied at a point in time, with revenue recognised when control transfers to the licensee and the licence period begins..74 Distinct licences that meet all of the following three criteria provide access to IP (and, thus, revenue is recognised over time): The licensor will undertake (either contractually or based on customary business practices) activities that significantly affect the IP to which the customer has rights. The licensor s activities do not otherwise transfer a good or service to the customer as they occur. The rights granted by the licence directly expose the customer to any effects (both positive and negative) of those activities on the IP and the customer entered into the contract with the intent of being exposed to those effects..75 The first criterion requires an assessment of whether a licensor might undertake activities that significantly affect the IP. These activities might result from published policies or customary practices, or they might be the result of the existence of a shared economic interest between the licensor and customer..76 The second criterion requires that the activities that might affect the IP are not additional performance obligations in the contract. Activities are not performance obligations if they do not directly transfer goods or services to a customer. A customer might be affected by the activities because they affect the IP; however, this effect could be either positive or negative..77 The third criterion requires that the effects (positive or negative) of any activities identified in the first criterion impact the customer. Activities that do not affect what the licence provides to the customer or what the customer controls do not meet this criterion. PwC observation: The revenue standard includes a number of examples that illustrate how an entity should apply the criteria to different licence arrangements. Applying these criteria could be challenging and will require judgement, especially to determine what constitutes an activity rather than a separate performance obligation. Different accounting conclusions might be reached for arrangements that appear to be similar, which could make comparability across entities and industries more challenging. Contract costs.78 An entity should recognise an asset for the incremental costs to obtain a contract if management expects to recover those costs. Incremental costs of obtaining a contract are costs the entity would not have incurred if the contract had not been obtained (for example, sales commissions). Costs that the entity would have incurred if the contract had not been obtained, such as facilities costs and sales force salaries, are not capitalised. An entity can elect to expense the cost of obtaining a contract if the amortisation period would be one year or less. These materials were downloaded from Inform ( under licence.page 16 / 307

17 .79 An entity will recognise an asset for costs to fulfil a contract if those costs: relate directly to a contract or anticipated contract that the entity can specifically identify; generate or enhance the entity s resources that will be used to satisfy future performance obligations; and are expected to be recovered..80 Management will need to consider whether costs to fulfil a contract should be accounted for in accordance with other standards (for example, inventory, fixed assets, or intangible assets) before applying the revenue standard. Costs that relate to satisfied performance obligations are expensed as incurred. PwC observation: The guidance on contract costs is expected to result in the recognition of more assets than under current practice. Entities that expense sales commissions as paid and set-up costs as incurred could now be required to capitalise and amortise these costs if they are recoverable..81 An asset recognised for the costs to obtain or fulfil a contract will be amortised on a systematic basis as the goods or services to which the assets relate are transferred to the customer. The asset will also be assessed for impairment each reporting period. Repurchase agreements.82 An entity that has an obligation or right to repurchase an asset (a forward or a call option) has not transferred control of the asset to the customer because the customer is limited in its ability to direct the use of and obtain substantially all of the remaining benefit from the asset. An entity will account for the contract as a lease if the entity can or must repurchase the asset for a price that is less than the original selling price, unless the contract is part of a sale-leaseback transaction. An entity will account for a contract as a financing if it can or must repurchase the asset for a price that is equal to or greater than the original selling price of the asset. When comparing the repurchase price to the selling price an entity should consider the time value of money..83 An arrangement where a customer has the right to require the entity to repurchase an asset (a put option) at a repurchase price less than the original selling price will be accounted for as a lease if the arrangement provides the customer a significant economic incentive to exercise that right, unless the contract is part of a sale-leaseback transaction. The arrangement is a financing if the repurchase price of the asset is equal to or exceeds the original selling price and is more than the expected market value of the asset..84 An arrangement is a sale of a product with a right of return, as discussed in paragraph 91, if the customer has a repurchase right at an amount less than the original selling price (or greater than or equal to the original selling price but less than the expected market value), but does not have a significant economic incentive to exercise that right. Principal versus agent.85 Entities often involve third parties when providing goods and services to their customers. Management needs to assess, for each performance obligation in a contract, whether the entity is acting as the principal or as an agent in such arrangements. An entity recognises revenue on a gross basis if it is the principal in the arrangement, and on a net basis (that is, equal to the fee or commission received) if it is acting as an agent. These materials were downloaded from Inform ( under licence.page 17 / 307

18 .86 An entity is the principal in an arrangement if it obtains control of the goods or services of another party in advance of transferring control of those goods or services to a customer. The entity is an agent if its performance obligation is to arrange for another party to provide the goods or services. An entity will need to evaluate if and when it obtains control. If an entity obtains legal title of a product only momentarily before the title is transferred to the customer, this does not necessarily indicate that the entity is acting as the principal in the arrangement..87 Indicators that the entity is an agent include: Fulfilment - The entity does not have primary responsibility for fulfilment of the contract. Inventory risk - The entity does not have inventory risk at any point during the transaction (that is, before the order, during shipment, or upon return). Pricing - The entity does not have discretion in establishing prices for the other party s good or service. Credit risk - The entity does not have customer credit risk for the amount of the receivable. Commission - The entity s consideration is in the form of a commission. PwC observation: The indicators in the revenue standard are similar to the current guidance in IFRS and US GAAP. However, the specific requirement for the entity to obtain control differs from current guidance. The revenue standard does not weigh any of the indicators more heavily than others, unlike existing US GAAP. New and evolving business models, especially related to internet transactions, have resulted in an increased focus in this area. We expect that entities will continue to apply judgement to assess whether to recognise revenue on a gross or net basis for many of these transactions, similar to today. Options to acquire additional goods or services.88 Entities often grant customers the option to acquire additional goods or services free of charge or at a discount. These options might include customer award credits or other sales incentives and discounts, such as volume discounts. An option gives rise to a separate performance obligation if it provides a material right to the customer that the customer would not receive without entering into the contract. The entity will recognise revenue allocated to an option when the additional goods or services are transferred to the customer, or the option expires..89 An example of a material right is a discount that is incremental to the range of discounts typically given to a similar class of customers in the same market. The customer is effectively paying in advance for future goods or services and therefore revenue is recognised when those future goods or services are transferred..90 Management will need to determine the stand-alone selling price for the option. Often the option will not have a directly observable selling price; therefore, management will need to estimate the stand-alone selling price. This estimate is adjusted for any discount the customer would receive without exercising the option and the likelihood that the customer will exercise the option. The revenue standard includes several examples related to customer options as well as the treatment of unexercised rights. PwC observation: The guidance related to options that provide the customer with a material right could have a significant effect on entities in a number of industries. For example, entities within the retail and These materials were downloaded from Inform ( under licence.page 18 / 307

19 consumer industry that provide customers with a loyalty program will need to consider whether the rewards issued by the program provide a material right. A portion of the transaction price will be allocated to the reward if it is a material right and a distinct performance obligation. This is different than current practice for entities applying an incremental cost model under US GAAP today. Rights of return.91 An entity will account for the sale of goods with a right of return by recognising revenue for the consideration it expects to be entitled to (considering the products expected to be returned) and a liability for the refund it expects to pay to customers, similar to current accounting under IFRS and US GAAP. Amounts are updated for changes in expected returns each reporting period. Exchanges by customers for products of the same type, quality, condition, and price are not considered returns..92 The entity will recognise an asset and corresponding adjustment to cost of sales for the right to recover goods from customers. The asset is initially measured at the original cost of the goods less any expected costs to recover those goods. Impairment is assessed at each reporting date. The entity should present the asset separately from the refund liability (that is, the entity should not present a net balance in the financial statements). The revenue standard includes an example that illustrates the journal entries that an entity would record to account for estimated product returns. Warranties.93 An entity accounts for a warranty as a separate performance obligation if the customer has the option to purchase the warranty separately. An entity accounts for a warranty as a cost accrual if it is not sold separately, unless the warranty is to provide the customer with a service in addition to assurance that the product complies with agreed-upon specifications..94 An entity should consider factors such as whether the warranty is required by law, the length of the warranty period, and the nature of the tasks the entity has promised to perform as part of the warranty to determine whether the warranty provides the customer with an additional service. Judgement will be required in this assessment. The portion of a warranty that provides a service in addition to assurance that the product complies with specifications is accounted for as a separate performance obligation. An entity that cannot reasonably separate the obligation to provide an additional service from the rest of the warranty should account for both together as a single performance obligation providing a service. PwC observation: The guidance on accounting for warranties is generally consistent with current guidance in IFRS and US GAAP. However, it might be challenging to separate a single warranty that provides both a standard warranty and an additional service in some arrangements. Management will have to develop processes to estimate stand-alone selling prices and allocate the transaction price between the performance obligations in the arrangement when such services are not sold separately. Non-refundable upfront fees.95 Some entities charge a customer a non-refundable fee at the beginning of an arrangement. Examples include set-up fees, activation fees, and joining fees. Management needs to determine whether a non-refundable upfront fee relates to the transfer of a promised good or service to a customer. These materials were downloaded from Inform ( under licence.page 19 / 307

20 .96 A non-refundable upfront fee might relate to an activity undertaken at or near contract inception. Similar to current accounting under IFRS and US GAAP, the activity does not result in the transfer of a promised good or service to the customer unless the entity has satisfied a separate performance obligation. The upfront fee is recognised as revenue when goods or services are provided to the customer in the future. Depending on the nature of the fee, the period of revenue recognition could extend beyond the initial contractual period if the entity grants the customer the option to renew the contract and that option provides the customer with a material right. Bill-and-hold arrangements.97 In a bill-and-hold arrangement, an entity bills a customer for a product but retains physical possession of the product until a later date. Revenue is recognised upon transfer of control of the goods to the customer (that is, the customer has the ability to direct the use of and obtain substantially all of the remaining benefits from the asset). In addition to applying the control guidance in the standard, all of the following requirements must be met to recognise revenue in a bill-and-hold arrangement: The reason for the customer requesting the bill-and-hold arrangement is substantive. The product is ready for physical transfer to the customer and separately identified as the customer s product. The entity cannot use the product or direct the product to another customer..98 An entity will need to consider whether it is providing custodial services to the customer that might be a separate performance obligation if the bill-and-hold criteria are met. Custodial services that are a separate performance obligation will result in a portion of the transaction price being allocated to that service. PwC observation: The list of indicators for bill-and-hold transactions is generally consistent with the current guidance under IFRS. There might be situations where revenue is recognised earlier compared to current US GAAP for bill-and-hold arrangements because there is no longer a requirement for the vendor to have a fixed delivery schedule from the customer in order to recognise revenue. Transfers of assets that are not an output of an entity s ordinary activities.99 The revenue standard also amends existing requirements for gain or loss recognition on the transfer of certain non-financial assets that are not the output of an entity s ordinary activities. Specifically, ASC 360, Property, Plant and Equipment, ASC 350, Intangibles Goodwill and Other, IAS 16, Property, Plant and Equipment, IAS 38, Intangible Assets, and IAS 40, Investment Property, were modified. US GAAP reporters will apply the concepts related to the existence of a contract, recognition, and measurement (including the constraint on revenue) to these arrangements. IFRS reporters will apply the concepts related to control and measurement to these arrangements. The revenue standard will be applied to determine when the asset should be derecognised and determine the consideration to be included in the net gain or loss recognised on transfer of these assets. Consignment arrangements.100 It is common in certain industries for entities to transfer goods to dealers or distributors on a consignment basis. The transferor typically owns the inventory until a specified event occurs, such as the sale of the product to an end customer. Revenue should not be recognised in a These materials were downloaded from Inform ( under licence.page 20 / 307

21 consignment arrangement until the transferor no longer controls the asset..101 Management should consider the following common characteristics to determine if an arrangement is a consignment arrangement: The entity holding the goods does not have an unconditional obligation to pay for the goods. The entity can require return of the product or transfer to another distributor (which indicates that control has not transferred to the distributor). The goods are controlled by the entity until a specified event occurs. Disclosures.102 The revenue standard requires a number of disclosures intended to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and the related cash flows. The disclosures include qualitative and quantitative information about contracts with customers, significant judgements made in applying the revenue guidance, and assets recognised from the costs to obtain or fulfil a contract..103 The disclosures are required for each period a statement of comprehensive income is presented and as of each period a statement of financial position is presented. Non-public entities (FASB only) are exempt from certain of the disclosure requirements. See the Appendix for a listing of these required disclosures. PwC observation: The disclosure requirements are significantly greater than existing disclosure requirements for revenue under IFRS and US GAAP. The revenue standard could add significant disclosures for interim financial statements as well. This could require new systems, processes, and internal controls to capture information that has historically not been needed for financial reporting purposes, particularly in interim financial statements. The standard includes several examples that illustrate specific aspects of the disclosure requirements. However, entities will need to tailor the sample disclosures for their specific facts and circumstances. What s next.104 Entities will apply the revenue standard in the first interim period within annual reporting periods beginning on or after 1 January 2017 (IFRS) and 15 December 2016 (US GAAP public entities). For example, 1 January 2017 will be the date of initial application for an entity with a 31 December 2017 year end. Earlier adoption is not permitted under US GAAP, but is permitted under IFRS..105 The standard will be effective for annual reporting periods beginning after 15 December 2017 for non-public entities (US GAAP only). Earlier application is permitted for non-public entities; however, no earlier than the effective date for public entities. Non-public entities will be required to apply the new standard to interim periods within annual reporting periods beginning after 15 December An entity can apply the revenue standard retrospectively to each prior reporting period presented (full retrospective method) or retrospectively with the cumulative effect of initially applying the standard recognised at the date of initial application in retained earnings (simplified transition method)..107 An entity that elects to apply the standard using the full retrospective method can apply certain practical expedients: These materials were downloaded from Inform ( under licence.page 21 / 307

22 For completed contracts, an entity need not restate contracts that begin and end within the same annual reporting period. For completed contracts that have variable consideration, an entity can use hindsight and use the transaction price at the date the contract was completed. For all reporting periods presented before the date of initial application (for example, 1 January 2017 for an entity with a 31 December year-end), an entity is not required to disclose the amount of transaction price allocated to the remaining performance obligations and an explanation of when the entity expects to recognise that amount as revenue..108 An entity that elects to use the simplified transition method must disclose this fact in its financial statements. An entity using this method will apply the revenue standard only to contracts that are not completed (that is, the entity has not transferred all of the goods or services promised in the contract) as of the date of initial application. Entities are also required to disclose the amount by which each financial statement line item is affected by the adoption in the year of initial application. PwC observation: The simplified transition method is intended to reduce the transition time and effort for preparers that choose this option. The requirement for entities to disclose the impact to each financial statement line item will effectively result in an entity applying both the new revenue standard and the previous revenue guidance in the year of initial application. The boards provided a longer than typical period of time for transition because of the pervasiveness of the standard and the importance of reporting revenue. It is intended to ensure that there is sufficient time for entities that want to use the full retrospective method as well as for those that use the simplified transition method, given the concerns of preparers about the amount of effort adopting the standard might require. Full retrospective application provides stronger trend information that some entities might prefer to provide to investors, so it was important to provide sufficient time for these preparers to transition. Appendix: Disclosure requirements Disclosure type Disaggregation of revenue Reconciliation of contract balances Disclosure requirements Disclose disaggregated revenue information in categories (such as type of good or service, geography, market, type of contract, etc.) that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. Provide sufficient disclosure to enable a user to understand the relationship between the disaggregated information and the revenue information disclosed for each reportable segment (IFRS 8 or ASC 280). Disclose opening and closing balances of contract assets and liabilities and provide a qualitative and quantitative description of significant changes in these amounts. Disclose the amount of revenue recognised that was included in the contract liability balance at the beginning of the period. Disclose the amount of revenue recognised in the current period relating to performance obligations satisfied in a prior period (such as from contracts with variable consideration). Disclose how the timing of the satisfaction of a These materials were downloaded from Inform ( under licence.page 22 / 307

23 performance obligation relates to the timing of payment. Discuss the effect on the contract asset and liability balances related to any timing difference. Performance obligations Disclose information about performance obligations, including: When performance obligations are typically satisfied. Significant payment terms. Nature of the goods or services promised to be transferred. Obligations for returns, refunds, or other similar obligations. Types of warranties and related obligations. Remaining performance obligations Costs to obtain or fulfil contracts Other qualitative disclosures Disclose the amount of the transaction price allocated to any remaining performance obligations not subject to significant revenue reversal. Disclose when the entity expects to recognise revenue associated with the transaction price allocated to the remaining performance obligations. Qualitatively describe any significant contract renewal and variable consideration not included within the transaction price. Disclose the closing balances, by main category of asset, of capitalised costs to obtain and fulfil a contract and the amount of amortisation in the period. Disclose the method used to determine the amount of costs incurred and the amortisation for each reporting period. Disclose significant judgements and changes in judgements that affect the amount and timing of revenue, including: timing of satisfaction of performance obligations; and transaction price and amount allocated to performance obligations. For performance obligations satisfied over time disclose: methods used to recognise revenue (output or input method used and how applied); and why method used faithfully depicts transfer of goods or services. For performance obligations satisfied at a point in time disclose significant judgements made in evaluating when customer obtains control. Disclose information about the inputs, methods, and assumptions used to determine the transaction price, assess whether variable consideration is constrained, These materials were downloaded from Inform ( under licence.page 23 / 307

24 allocate transaction price, and determine the stand-alone selling price. Disclose how management determines the minimum amount of revenue not subject to the variable consideration constraint. Describe the practical expedients, including those for transition, used in an entity s revenue accounting policies. Interim period disclosures IFRS reporters are required to only include the disclosures related to disaggregation of revenue. US GAAP reporters are required to disclose the following in accordance with ASC 270: Disaggregation of revenue disclosure. Contract balances disclosures. Revenue recognised in the reporting period that was included in the contract liability balance at the beginning of the period. Remaining performance obligation disclosures. Information about the entity s remaining performance obligations as of the end of the reporting period. Engineering and construction industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for engineering and construction entities as they transition to the new standard. Overview Entities in the engineering and construction (E&C) industry applying IFRS or US GAAP have primarily been following industry guidance for construction contracts 1 to account for revenue. These standards were developed to address particular aspects of long-term construction accounting and provide guidance on a wide range of industry-specific considerations including: Defining the contract, such as when to combine contracts, and when and how to account for change orders and other modifications. Defining the contract price, including variable consideration, customerfurnished materials, and claims. Recognition methods, such as the percentage-of-completion method (and, in These materials were downloaded from Inform ( under licence.page 24 / 307

25 the case of US GAAP, the completed contract method) and input/output methods to measure performance. Accounting for contract costs, such as pre-contract costs and costs to fulfil a contract. Accounting for loss-making contracts. The new revenue standard will replace the construction contract guidance and substantially all existing revenue recognition guidance under IFRS and US GAAP. This includes the percentageof-completion method and the related construction cost accounting guidance as a stand-alone model. Defining the contract Current guidance covers: When two or more contracts should be combined and accounted for together. When one contract should be segmented and accounted for separately as two or more contracts. When a contract modification should be recognised. These situations and, in particular, contract modifications such as change orders, are commonplace in the E&C industry. The new standard applies only to contracts with customers that meet the following criteria: The contract has commercial substance. The contract has been approved by the parties to the contract and such parties are committed to satisfying their perspective obligations. It is probable that the entity will collect the consideration to be received in exchange for the goods or services to be transferred to the customer. The contract has enforceable rights that can be identified regarding the goods or services to be transferred. The payment terms can be identified. Current practice is not expected to significantly change in the assessment of whether contracts should be combined. The standard does not contain guidance on segmenting contracts; however, construction companies that segment contracts under current guidance might not be significantly affected because of the requirement to account for separate performance obligations (refer to Accounting for multiple performance obligations below). Construction companies currently exercise significant judgement to determine when to include change orders and other contract modifications in contract revenue and therefore there is diversity in practice. We expect that the use of judgement will continue to be needed and do not expect current practice (or existing diversity) in this area to be significantly affected by the new standard, including the accounting for unpriced change orders. New standard Current US GAAP Current IFRS Combining contracts Two or more contracts (including contracts with parties related to the customer) are combined and accounted for as one contract if the contracts are entered into at or near the same time Combining and segmenting contracts is permitted provided certain criteria are met, but it is not required so long as the underlying economics of the transaction are fairly reflected. Combining and segmenting contracts is required when certain criteria are met. These materials were downloaded from Inform ( under licence.page 25 / 307

26 and one or more of the following conditions are met: The contracts are negotiated with a single commercial objective. The amount of consideration in one contract depends on the other contract. The goods or services promised are a single performance obligation (refer to Accounting for multiple performance obligations below). Contract modifications (for example, change orders) An entity will account for a modification if the parties to a contract approve a change in the scope and/or price of a contract. If the parties have approved a change in the scope, but have not yet determined the corresponding change in price (for example, unpriced change orders), the entity should estimate the change to the contract price as variable consideration. A contract modification is accounted for as a separate contract if: A change order is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. US GAAP also includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be performed is defined, but the price is not). A change order (known as a variation) is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders. the modification promises distinct These materials were downloaded from Inform ( under licence.page 26 / 307

27 goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the additional goods or services. A modification that is not a separate contract is accounted for either as: A prospective adjustment if the goods or services in the modification are distinct from those transferred before the modification. The remaining consideration in the original contract is combined with the consideration promised in the modification to create a new transaction price that is then allocated to all remaining performance obligations. A cumulative adjustment to contract revenue if the These materials were downloaded from Inform ( under licence.page 27 / 307

28 remaining goods and services are not distinct and are part of a single performance obligation that is partially satisfied. Example 1 - Unpriced change orders Facts: A contractor has a single performance obligation to build an office building. The contractor has a history of executing unpriced change orders; that is, those change orders where price is not defined until after scope changes are agreed upon. It is not uncommon for the contractor to commence work once the parties agree to the scope of the change, but before the parties agree on the price. When would these unpriced change orders be included in contract revenue? Discussion: The contractor might be able to determine that it expects the price of the scope change to be approved based on its historical experience. If so, after the scope changes are approved, the contractor will account for the unpriced change order as variable consideration. The contractor will estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is more predictive) provided that it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur when the price of the change order is approved. The contractor will need to determine whether the unpriced change order is accounted for as a separate contract. This will often not be the case based on the following: Change orders often don t provide distinct goods or services because they are highly interrelated with the goods or services in the original contract, and are part of the contractor s service of integrating goods and services into a combined item for the customer. Change orders are typically based on the contractor s goal of obtaining one commercial objective for the overall contract. The pricing of a change order may, as a result, not represent the stand-alone selling price of the additional goods or services. The contractor in this case will update the transaction price and measure of progress toward completion of the contract (that is, a cumulative catch-up adjustment) because the remaining goods or services, including the change order, are not distinct and are part of a single performance obligation that is partially satisfied. Change orders often don t provide distinct goods or services because they are highly interrelated with the goods or services in the original contract, and are part of the contractor s service of integrating goods and services into a combined item for the customer. Change orders are typically based on the contractor s goal of obtaining one commercial objective for the overall contract. The pricing of a change order may, as a result, not represent the stand-alone selling price of the additional These materials were downloaded from Inform ( under licence.page 28 / 307

29 goods or services. The contractor in this case will update the transaction price and measure of progress toward completion of the contract (that is, a cumulative catch-up adjustment) because the remaining goods or services, including the change order, are not distinct and are part of a single performance obligation that is partially satisfied. Determining the transaction price The transaction price (or contract revenue) is the consideration the contractor expects to be entitled to in exchange for satisfying its performance obligations. This determination is more complex when the contract price is variable. Common considerations in this area for E&C include the accounting for awards or incentive payments, customer-furnished materials, claims, liquidated damages, and the time value of money. Revenue related to awards or incentive payments might be recognised earlier under the new standard in some situations. A significant change in practice as it relates to customer-furnished materials, claims, liquidated damages, and the time value of money is not expected. New standard Current US GAAP Current IFRS Awards/incentive payments Awards/incentive payments are accounted for as variable consideration. They are included in contract revenue using the expected value or most likely amount approach (whichever is more predictive of the amount the entity expects to be entitled to receive). These amounts are included in the transaction price only if it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur in the future. Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. An entity should assess its experience with similar types of performance obligations and determine whether, based on that experience, the entity expects a significant reversal in future periods in the cumulative amount of revenue recognised. Customer-furnished materials The value of goods or services contributed by a customer (for example, materials, equipment, or labour) to The value of customerfurnished materials is included in contract revenue when the contractor has the associated risk for these materials. These materials were downloaded from Inform ( under licence.page 29 / 307 There is no explicit guidance on the accounting for non-cash consideration in the construction contracts standard. Management follows

30 facilitate the fulfilment of the contract is included in contract revenue (as non-cash consideration) if the entity controls these goods or services after they are provided. Non-cash consideration is measured at fair value unless fair value cannot be reasonably estimated, in which case it is measured by reference to the selling price of the goods or services transferred. general principles on nonmonetary exchanges, which generally require companies to use the fair value of goods or services received in measuring the amount to be included in contract revenue. Claims Claims are accounted for as variable consideration. They are included in contract revenue using the expected value or most likely amount approach (whichever is more predictive of the amount the entity expects to be entitled to receive) provided that it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the claim is subsequently resolved. Time value of money Contract revenue should reflect the time value of money whenever the contract includes a significant financing component. An entity is not required to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less, as a practical expedient. All relevant facts and circumstances should be considered when assessing if a contract contains a significant financing component. A claim is recorded as contract revenue when it is probable and can be estimated reliably (determined based on specific criteria), but only to the extent of contract costs incurred. Profits on claims are not recorded until they are realised. Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. The interest component is computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable when discounting is required. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured. Revenue is discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate is used to determine the amount of revenue to be recognised as well as the separate interest income to be recorded over time. These materials were downloaded from Inform ( under licence.page 30 / 307

31 Example 2 - Variable consideration Facts: A contractor enters into a contract for the expansion of an existing two-lane highway to a three-lane highway. The contract price is C65 million plus a C5 million award fee if the expansion is complete before the holiday travel season. The contract is expected to take one year to complete. The contractor has a long history of performing this type of highway work. The award fee is binary; that is, if the job is finished before the holiday travel season, the contractor receives the full award fee. The contractor does not receive any award fee if the highway is not finished before the holiday season. The contractor believes, based on its significant past experience, that it is 95 percent likely that the contract will be completed in advance of the holiday travel season. How should the contractor account for the award fee? Discussion: The contractor is likely to conclude, given the binary award fee, that it is appropriate to use the most likely amount approach to determine the amount of variable consideration to include in the estimate of the transaction price. The contract s transaction price is therefore C70 million: the fixed contract price of C65 million plus the C5 million award fee (the most-likely amount). This estimate is regularly revised and adjusted, as appropriate, using a cumulative catch-up approach, which is consistent with current practice. The contractor will then assess, based on its experience with similar types of performance obligations, whether it is highly probable (IFRS) or probable (US GAAP) that the award fee included in the transaction price will not be subject to a significant reversal when the contract is completed. Factors to consider in making this assessment include, but are not limited to: The contractor has a long history of performing this type of work. It is largely within the contractor s control to complete the work before the holiday travel season. The uncertainty will be resolved within a relatively short period of time. There are only two possible final consideration amounts. This assessment will determine whether the award fee is eligible to recognise as revenue when the performance obligation is satisfied (that is, as the construction occurs). Example 3 - Claims Facts: Assume the same fact pattern as Example 2, except that due to reasons outside of the contractor s control (for example, customer-caused delays), the cost of the contract far exceeds original estimates, but a profit is still expected. The contractor submits a claim against the customer to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with customers, albeit sometimes at a discount from the amount sought. How should the contractor account for the claim? Discussion: Claims are highly susceptible to external factors (such as the judgement of, or negotiations with, third parties), and the possible outcomes are highly variable. The contractor might have experience in successfully negotiating claims, but it might be challenging to assert that such experience has predictive value in this fact pattern (because of the highly uncertain variables). The contractor might therefore conclude that it is highly probable (IFRS) or probable (US GAAP) that the amount of the claim, if recognised, could be subject to significant reversal in future periods. The amount of the claim is excluded from the transaction price (contract revenue) until the contractor determines it is highly probable (IFRS) or probable (US GAAP) it will not be subject to significant reversal in future periods. The contractor will then estimate the amount of the claim These materials were downloaded from Inform ( under licence.page 31 / 307

32 using the expected value method (which is more predictive in this fact pattern) and include the amount not subject to significant reversal in the transaction price. It could be highly probable (IFRS) or probable (US GAAP) that some portion of the claim will not result in a significant revenue reversal, such as when a contractor can demonstrate that specific direct costs were incurred as a result of the customer-caused delay. Based on the underlying contractual terms, the contractor might determine that it has an enforceable right to receive payment from its customer. If the contractor has a history of successful negotiations it might therefore conclude that it is highly probable (IFRS) or probable (US GAAP) that a portion (that is, a minimum amount) of the claim will not be subject to significant reversal in the future periods. The contractor will need to reassess the estimates of the claim amount at each reporting date until the uncertainty is resolved. Example 4 - Time value of money Facts: A contractor enters into a contract for the construction of a hospital that includes scheduled milestone payments. The performance obligation will be satisfied over time and the contractual milestone payments are estimated to coincide with the revenue to be earned. The contract specifies that the customer will retain 5% of each milestone payment and the retainage will be paid to the contractor only when the hospital is complete. Does the contract include a significant financing component? Discussion: The contractor will likely conclude that the contract does not include a significant financing component and therefore will not reflect the time value of money in the transaction price. The milestone payments are estimated to coincide with the contract revenue to be earned. Further, the contract requires amounts to be retained for reasons other than to provide financing; that is, retainage is intended to protect the customer from the contractor failing to adequately complete some or all of its obligations under the contract. Accounting for multiple performance obligations Performance obligations are promises to deliver goods or perform services. Contractors often account for each contract at the contract level today; that is, contractors account for the macropromise in the contract (for example, to build a road or build a refinery). Current guidance permits this approach, although a contractor effectively promises to provide a number of different goods or services in delivering such macro-promises. Determining when to separately account for these performance obligations under the new standard will require judgement. It is possible to account for a contract at the contract level (for example, the macro-promise to build a road) under the new standard when the criteria for combining a bundle of goods or services into one performance obligation are met. Judgement will be needed in many situations to determine if all of the promises in the contract should be bundled together, particularly when assessing contracts such as engineering, procurement, and construction (EPC) or design / build contracts. New standard Current US GAAP Current IFRS An entity should assess the goods or services promised in a contract and identify as a performance obligation each promise to transfer to a customer either: a. A good or service The basic presumption is that each contract is the profit centre for revenue recognition, cost accumulation, and income measurement. That presumption may be overcome only if a contract or a series of contracts meets the conditions described above for These materials were downloaded from Inform ( under licence.page 32 / 307 The basic presumption is that each contract is the profit centre for revenue recognition, cost accumulation, and income measurement. That presumption is overcome when a contract or a series of contracts meets the conditions described for combining or

33 (or bundle of goods or services) that is distinct. A series of distinct b. goods or services that are homogenous and meet both of the following criteria: combining or segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract under the construction contract guidance. segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract. Each distinct good or service that is transferred consecutively is a performance obligation satisfied over time. The same method would be used to measure the entity s progress toward satisfying the performance obligation for each distinct good or service. A good or service is distinct if both of the following criteria are met: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. The entity s promise to transfer the good or These materials were downloaded from Inform ( under licence.page 33 / 307

34 service to the customer is separable from other promises in the contract. Factors that indicate a performance obligation is separable from other promises in the contract include, but are not limited to: The goods or services are not highly dependent on or interrelated with other goods or services in the contract. The entity does not provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted. The goods or services do not significantly modify or customise another good or service in the contract. Goods and services that are not distinct and therefore not separate performance obligations should be combined with other goods or services until the entity identifies a bundle of goods or services that is distinct. These materials were downloaded from Inform ( under licence.page 34 / 307

35 Example 5 - Design and build contract Facts: A contractor enters into a contract to design and build an airport terminal. The contractor is responsible for the design and overall management of the project build, including engineering, site clearance, foundation, procurement, construction of terminal space, gates with loading bridges, customs and immigration, airline office space, distribution systems required for its operations, and installation of equipment and finishing. How many distinct performance obligations are in the contract? Discussion: The contractor will likely account for the design and build contract as a single performance obligation because these goods and services are not distinct. The goods and services are highly interrelated and the contract includes a significant service of integrating the goods and services into the combined item the customer contracted for; that is, the airport terminal. Revenue is recognised over time by selecting an appropriate measure of progress toward satisfaction of the single performance obligation. Example 6 - Procurement of specialised equipment Facts: Assume the same fact pattern as Example 5 above, except the contract requires the contractor to procure specialised equipment from a subcontractor and integrate the equipment into the airport terminal. The contractor expects to transfer control of the equipment approximately one year from the contract inception. The installation and integration of the equipment continue throughout the contract. How many distinct performance obligations are in the contract? Discussion: The contractor will likely account for the design and build contract as well as the procurement of specialised equipment as a single performance obligation. The goods and services in the bundle are highly interrelated and providing them to the customer requires the contractor also provide significant services of integrating the services into the combined item the customer has contracted to receive (the airport terminal). Revenue is recognised over time by selecting an appropriate measure of progress toward satisfaction of the performance obligation. (See discussion of accounting for uninstalled materials in Example 12 below.) Allocating the transaction price The transaction price is allocated to the performance obligations in a contract that require separate accounting. Of particular interest will be the allocation of variable consideration (for example, award or incentive payments) associated with only one performance obligation, rather than the contract as a whole. An entity can allocate the transaction price entirely to one (or more) performance obligations when certain conditions are met. New standard Current US GAAP Current IFRS The transaction price (and any Except for allocation guidance Except for allocation guidance subsequent changes in related to contract related to contract estimate of the transaction segmentation, there is no segmentation, there is no price) is allocated to each explicit guidance on allocating explicit guidance on allocating separate performance contract revenue to multiple contract revenue to multiple obligation based on the deliverables in a construction deliverables in a construction relative stand-alone selling contract, given the contract, given the presumption price of each performance presumption that the contract that the contract is the profit obligation. The best evidence is the profit centre for centre for determining revenue of a stand-alone selling price determining revenue recognition. is the observable price of a recognition. good or service when sold separately. These materials were downloaded from Inform ( under licence.page 35 / 307

36 The stand-alone selling price should be estimated if the actual selling price is not directly observable. The standard does not prescribe a specific estimation method. For example, a contractor might use cost plus a reasonable margin to estimate the selling price of a good or service. An entity should maximise the use of observable inputs when estimating the stand-alone selling price. Entities may use a residual approach to estimate the stand-alone selling price if the stand-alone selling price of a good or service is highly variable or uncertain. An entity may also allocate a discount or an amount of contingent consideration entirely to one (or more) performance obligations if certain conditions are met. Example 7 - Allocating contract revenue to more than one performance obligation Facts: A contractor enters into a contract to build both a road and a bridge (assume there are two separate performance obligations: building the road and building the bridge). The contractor determines at inception that the contract price is C151 million, which includes a C140 million fixed price and an estimated C11 million award fee. The amount of the award fee is variable depending on how early the contractor finishes the project. The contractor will receive a base award fee of C10 million if it finishes the project 30 days ahead of schedule. The award fee increases (decreases) by 10% for each day before (after) the 30 days it finishes the project. The contractor has experience with similar contracts. The contractor uses the most likely amount to estimate the variable consideration associated with the incentive bonus of C10 million. Based on the contractor s prior experience and its current estimates, the contractor determines that it will finish the project 30 days ahead of schedule and be entitled to the C10 million award fee. The contractor uses the expected value method to estimate the additional variable consideration associated with the 10% daily penalty or incentive and determines it will be entitled to a 10% increase or C1 million. The contractor concludes that it is highly probable (IFRS) or probable (US GAAP) that a change in estimate would not result in a significant revenue reversal in the future. How should the contractor allocate the contract price to the two separate performance obligations? Discussion: The contractor must first assign a stand-alone selling price to each of the road and the bridge in order to allocate the contract price (including both the fixed and variable amounts). The contractor constructs roads and bridges of a similar type and nature to those required by the contract on a stand-alone basis. The stand-alone selling price of the road, based on prior These materials were downloaded from Inform ( under licence.page 36 / 307

37 experience, is C140 million. The stand-alone selling price of the bridge, based on prior experience, is C30 million. There is an inherent discount of C19 million built into the bundled contract. The C151 million transaction price is allocated as follows using a relative allocation model: Road: C124.4m (C151m * (C140m / C170m)) Bridge: C 26.6m (C151m * (C 30m / C170m)) Example 8 - Allocating contract revenue changes in the transaction price Facts: Assume the same fact pattern as Example 7 above, except that the amount of variable consideration changes from an expected C11 million to an expected C13 million after contract inception. The changes are due to improved weather conditions during the construction period and therefore an expectation that the contractor will complete the entire project earlier than expected. How should the contractor allocate the change in the estimated contract price? Discussion: The basis for allocating the transaction price to performance obligations (that is, the percentage used to allocate based on relative stand-alone selling prices) does not change after contract inception. The additional C2 million of transaction price is allocated to the road and bridge using the initially developed allocation percentages as follows: Road: C1.6m (C2m * (C140m / C170m)) Bridge: C0.4m (C2m * (C 30m / C170m)) The change in estimate is recognised using a cumulative catch-up approach. For example, if the road is 90% complete and work on the bridge has not yet commenced when the estimate changes, the contractor will recognise cumulative revenue of C113.4 million (C124.4 million x 90% +C1.6 million x 90%) for the portion of the performance obligation already satisfied for the road. The contractor will recognise additional revenue of C12.6 million (C124.4 million x 10% + C1.6 million x 10%) as the remaining performance obligations related to the road are satisfied and C27 million ((C26.6 million + C0.4 million) x 100%) as the bridge is completed. Assume the same fact pattern as above, except that the bridge is completed and the amount of the award fee only relates to the completion of the road. In this situation, the contractor will allocate the entire change in the estimated contract price of C2 million to the road. The contractor will recognise additional revenue of C1.8 million (C2 million x 90%) in the period of the change of estimate for the portion of the performance obligation already satisfied for the road. The contractor will recognise the remaining revenue of C12.6 million (C124.4 million x 10% + C2 million x 10%) as the remaining performance obligations related to the road are satisfied. Recognising revenue Revenue recognition under existing guidance is based on the activities of the contractor; that is, provided reasonable estimates are available, revenue can be recognised as the contractor performs (known as the percentage-of-completion method). Revenue is recognised under the new standard when a performance obligation is satisfied, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. The change to a control transfer model requires careful assessment of when a contractor can recognise revenue. Many construction-type contracts will transfer control of a good or service over time and therefore might result in a similar pattern of revenue recognition as today s guidance. This should not, however, be assumed. Contractors will not be able to default to the method used today, and will need to perform a careful assessment of when control transfers. New standard Current US GAAP Current IFRS These materials were downloaded from Inform ( under licence.page 37 / 307

38 Transfer of control Revenue is recognised upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps more common for the E&C industry, over time. A performance obligation is satisfied over time when at least one of the following criteria is met: The customer receives and consumes the benefits of the entity s performance as the entity performs. The entity s performance creates or enhances a customercontrolled asset. An asset with an alternative use to the entity is not created but the entity has a right to payment for performance completed to date. A performance obligation is satisfied at a point in time if it does not meet the criteria above. Determining when control transfers will require a significant amount of judgement. Indicators that might be considered in determining whether the customer has obtained control of an asset at a point in time Revenue is recognised using the percentage-of-completion method when reliable estimates are available. The percentage-of-completion method based on a zero-profit margin is used when reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (for example, when the scope of the contract is illdefined, but the contractor is protected from an overall loss) until more precise estimates can be made. The completedcontract method is required when reliable estimates cannot be made. These materials were downloaded from Inform ( under licence.page 38 / 307 Revenue is recognised using the percentage-of-completion method when reliable estimates are available. The percentage-of-completion method based on a zero-profit margin is used when reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall loss) until more precise estimates can be made. Contract costs that are not probable of being recovered are recognised as an expense immediately. The completedcontract method is prohibited.

39 include: The entity has a present right to payment. The customer has legal title. The customer has physical possession. The customer has the significant risks and rewards of ownership. The customer has accepted the asset. This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis. Measuring performance obligations satisfied over time A contractor should measure progress toward satisfaction of a performance obligation that is satisfied over time using the method that best depicts the transfer of goods or services to the customer. Methods for recognising revenue when control transfers over time include: Output methods that recognise revenue on the basis of direct measurement of the value to the customer of the entity s performance to date (for example, A contractor can use either an input method (for example, cost-to-cost, labour hours, labour cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress toward completion. There are two different approaches for determining revenue, cost of revenue, and gross profit once a percentage complete is derived: the Revenue method and the Gross Profit method. A contractor can use either an input method (for example, cost-to-cost, labour hours, labour cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress toward completion. IFRS requires the use of the Revenue method to determine revenue, cost of revenue, and gross profit once a percentage complete is derived. The Gross Profit method is not permitted. These materials were downloaded from Inform ( under licence.page 39 / 307

40 surveys of goods or services transferred to date, appraisals of results achieved). Input methods that recognise revenue on the basis of the entity s efforts or inputs to the satisfaction of a performance obligation (for example, cost-to-cost, labour hours, labour cost, machine hours, or material quantities). The method selected should be applied consistently to similar contracts with customers. Once the metric is calculated to measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognised. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognising revenue equal to the costs of the transferred goods if goods are transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). These materials were downloaded from Inform ( under licence.page 40 / 307

41 Estimates to measure the extent to which control has transferred (for example, estimated costs to complete when using a cost-to-cost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method. Example 9 - Recognising revenue Facts: A contractor enters into a construction contract with an owner to build an oil refinery. The contract has the following characteristics: The oil refinery is highly customised to the owner s specifications and changes to these specifications by the owner are expected over the contract term. The oil refinery does not have an alternative use to the contractor. Non-refundable, interim progress payments are required as a mechanism to finance the contract. The owner can cancel the contract at any time (with a termination penalty); any work in process is the property of the owner. As a result, another entity would not need to re-perform the tasks performed to date. Physical possession and title do not pass until completion of the contract. The contractor determines that the contract has a single performance obligation to build the refinery. How should the contractor recognise revenue? Discussion: The preponderance of evidence suggests that the contractor s performance creates an asset that the customer controls and control is being transferred over time. The contractor will have to select either an input or output method to measure the progress toward satisfying the performance obligation. Example 10 - Recognising revenue - use of cost-to-cost Facts: Assume the same fact pattern as Example 9 above. Additional contract characteristics are: Contract duration is three years. Total estimated contract revenue is C300 million. Total estimated contract cost is C200 million. Year one cost is C120 million (including C20 million related to contractorcaused inefficiencies). The contractor concludes that cost-to-cost is a reasonable method for measuring the progress toward satisfying its performance obligation. How much revenue and cost should the contractor recognise during the first year? Discussion: The contractor should exclude any costs that do not depict the transfer of goods or services to determine the amount of revenue to recognise under a cost-to-cost model. The costs These materials were downloaded from Inform ( under licence.page 41 / 307

42 associated with contractor-caused inefficiencies should be excluded in this situation. The amounts of contract revenue and cost recognised at the end of year one are: Revenue: Contract cost (excluding inefficiencies): Gross contract margin: Contract inefficiencies: Adjusted contract margin: C150m (C300m * (C100m / C200m)) C100m C 50m C 20m C 30m Example 11 - Recognising revenue - use of cost-to-cost with changes in estimates Facts: Assume the same fact pattern as Examples 9 and 10 above, except that the total estimated cost to complete the contract increases at the end of the second year to C250 million due to an increase in the cost of materials. Actual cumulative costs incurred as of the end of the second year (excluding year-one inefficiencies) is C200 million. How much revenue and cost should the contractor recognise during the second year? Discussion: The amount of contract revenue and cost recognised during the second year: Cumulative revenue: Revenue recognised year one: Revenue recognised year two: Cumulative costs (excluding inefficiencies): Costs recognised year one (excluding inefficiencies): Costs recognised year two: (excluding inefficiencies): Gross contract margin year two: C240m (C300m * (C200m / C250m) C150m C 90m C200m C100m C100m C (10m) (C90m - C100m) Gross contract margin todate (excluding inefficiencies): Adjusted contract margin todate: C 40m (C240m - C200m) C 20m (C240m - C200m - C20m) Example 12 - Recognising revenue uninstalled materials Facts: Assume the same fact pattern as Example 6 above and at contract inception the contractor estimates the following: Contract price: C100 million Contract costs: C50 million Cost of the specialised equipment: C20 million These materials were downloaded from Inform ( under licence.page 42 / 307

43 Discussion: The contractor concludes that including the costs to procure the specialised equipment in measuring progress would overstate the extent of the contractor s performance. Therefore, revenue should be recognised for the specialised equipment in an amount equal to the cost of the specialised equipment upon the transfer of control to the customer. As such, the contractor excludes the cost of the specialised equipment from its measure of progress toward complete satisfaction of the performance obligation on a cost-to-cost basis. During the first six months, the contractor incurs C25 million of costs compared to the total of C50 million of expected costs to complete (excluding the C20 million cost of the specialised equipment). Therefore, the contractor estimates that the performance obligation is 50 percent complete (C25 million C50 million) and recognises revenue of C40 million (50% (C100 million total transaction price C20 million revenue for the specialised equipment)). Upon transfer of control of the specialised equipment, the contractor recognises revenue and costs of C20 million. Subsequently, the contractor continues to recognise revenue on the basis of costs incurred relative to total expected costs (excluding the revenue and cost of the specialised equipment). Other considerations Warranties Most warranties in the construction industry provide coverage against latent defects. There is currently diversity in the way E&C companies account for these and other types of warranties. Warranty costs are either accounted for within contract accounting (for example, as a contract cost) or outside of contract accounting in accordance with the existing loss contingency guidance. We expect practice to become less diverse and potentially change significantly for some entities that utilise a cost-to-cost input method for measuring progress and do not currently include warranty as a contract cost. New standard Current US GAAP Current IFRS Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Contractors typically account for warranties that protect against latent defects outside of contract accounting and in accordance with existing loss contingency guidance. A contractor recognises revenue and concurrently accrues any expected cost for these warranty repairs. The warranty is accounted for as a cost accrual if a customer does not have the option to purchase a warranty separately from the entity. An entity might provide a warranty that calls for a service to be provided to the customer (for example, maintenance) in addition to a promise that the entity s past performance was as specified in the contract. The entity will account for the service component of the warranty as a separate performance obligation in these Revenue is deferred for warranties that protect against defects arising through normal usage (that is, extended warranties) and recognised over the expected life of the contract. Contractors are required to account for the estimated costs of rectification and guarantee work, including expected warranty costs, as contract costs. However, contractors typically account for standard warranties protecting against latent defects outside of contract accounting and in accordance with existing provisions guidance. A contractor will recognise revenue and concurrently accrue any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage (that is, extended warranties) and recognised over the expected life of the contract. These materials were downloaded from Inform ( under licence.page 43 / 307

44 circumstances. An entity that cannot reasonably account for an assurance warranty separately from services also provided under the warranty should account for both warranties together as a single performance obligation. Example 13 - Accounting for warranties Facts: Assume the same fact pattern as Example 9 above. The contractor also provides a warranty that covers latent defects for certain components of the oil refinery. This warranty is automatically provided by the contractor and the customer does not have an option to purchase the warranty separately from the contractor. How should the contractor account for such a warranty? Discussion: The contractor should account for this warranty as a cost accrual. Contractors who determine that cost-to-cost is an appropriate method to measure transfer of control over time might therefore have to consider these costs in their cost-to-cost calculation. Contract costs Existing construction contract guidance contains a substantial amount of cost capitalisation guidance, both related to pre-contract costs and costs to fulfil a contract. The new standard also includes contract cost guidance that could result in a change in the measurement and recognition of contract costs as compared to today. In particular, measurement and recognition could change for those contractors that currently use the Gross Profit method for calculating revenue and cost of revenue. New standard Current US GAAP Current IFRS All costs related to satisfied performance obligations and costs related to inefficiencies (that is, abnormal costs of materials, labour, or other There is a significant amount of detailed guidance relating to the accounting for contract costs within the construction contract guidance. This is costs to fulfil) are expensed as particularly true with respect to incurred. accounting for pre-contract costs. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained and are recognised as an asset if they are expected to be recovered. As a practical expedient, such costs may be expensed as incurred if the amortisation period of the asset that the entity otherwise would have recognised is one year or less. Costs to obtain a contract that would have been incurred Pre-contract costs that are incurred for a specific anticipated contract generally may be deferred only if their recoverability from that contract is probable. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance. These materials were downloaded from Inform ( under licence.page 44 / 307 There is a significant amount of detailed guidance relating to the accounting for contract costs. Costs that relate directly to a contract and are incurred in securing the contract are included as part of contract costs if they can be separately identified, measured reliably, and it is probable that the contract will be obtained. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance.

45 regardless of whether the contract was obtained (for example, certain bid costs) are recognised as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. Direct costs of fulfilling a contract are accounted for in accordance with other standards (for example, inventory, intangibles, fixed assets) if they are within the scope of that guidance. Direct costs of fulfilling a contract are capitalised under the new standard if not within the scope of other standards and if they relate directly to a contract, relate to future performance, and are expected to be recovered under the contract. Capitalised costs are amortised as control of the goods or services to which the asset relates is transferred to the customer, which may include goods or services to be provided under specific anticipated contracts (for example, a contract renewal). Example 14 - Accounting for contract costs Facts: Assume the same fact pattern as Examples 9 and 10 above. At the beginning of the contract, the contractor incurs certain mobilisation costs amounting to C1 million. The contractor has concluded that such costs should not be accounted for in accordance with existing asset standards (for example, inventory, fixed assets, or intangible assets). How should the contractor account for the mobilisation costs? Discussion: These costs to fulfil a contract would be capitalised if they: (a) relate directly to the contract; (b) relate to future performance; and (c) are expected to be recovered. Assuming the mobilisation costs meet these criteria and are capitalised, C500,000 would be amortised as of the end of year one (coinciding with 50 percent control transfer using a cost-to-cost method) using the fact pattern in Examples 9 and 10 above. Amortisation of capitalised mobilisation costs would be included in the measurement of the contractor s satisfaction of its performance obligation. Contract assets and liabilities These materials were downloaded from Inform ( under licence.page 45 / 307

46 Existing construction contract guidance requires a contractor to record an asset for unbilled accounts receivable when revenue is recognised but not billed. The unbilled accounts receivable is transferred to a billed accounts receivable when the invoice is submitted to the customer. Under the new standard, if a contractor delivers services to a customer before the customer pays consideration, the contractor should record either a contract asset or a receivable depending on the nature of the contractor s right to consideration for its performance. The transfer from a contract asset to an accounts receivable balance (when the contractor has a right to payment) may not coincide with the timing of the invoice as is required under the existing guidance. Cost in excess of billings and billings in excess of cost initially recognised on the balance sheet under current GAAP should be similar to the contract asset and contract liability recognised under the new standard. New standard Current US GAAP Current IFRS The entity should present either a contract asset or a receivable depending on the nature of the entity s right for its performance, if an entity Unbilled receivables arise when revenues have been recognised as the performance of contract work is being performed, but the recognises revenue before the amount cannot be billed under customer pays consideration. the terms of the contract until a later date. a. A contract asset is an entity s right to payment in exchange for goods or services that the entity has transferred to a customer, when that right is conditioned on something other than the passage of time (for example, the entity s future performance). b. A receivable is an entity s right to payment that is unconditional. If a customer make a payment or an amount of payment is due before an entity satisfied its performance obligations, the entity should present that amount as a contract liability. A contract liability is an entity s obligation to transfer goods or services to a customer for which the entity has received payment from the customer. Billings in excess of costs and estimated earnings represent obligations for work to be performed with the exception of when billings exceed total estimated costs at completion of the contract plus contract profits earned to date. A contractor may have incurred contract costs that relate to future activities on the contract. Such contract costs are recognised as an asset provided it is probable that they will be recovered. Such costs represent an amount due from the customer and are often classified as contract work in process. Advances received before the related work has been performed are recognised as a liability. These materials were downloaded from Inform ( under licence.page 46 / 307

47 Onerous performance obligations Existing construction contract guidance requires a loss to be recorded when the expected contract costs exceed the total anticipated contract revenue. Existing guidance related to the recognition of losses arising from contracts with customers will be retained for entities within the scope of that guidance. Final thoughts The above discussion does not address all aspects of the new standard. Companies should continue to evaluate how the new standard might change current business activities, including contract negotiations, key metrics (including debt covenants, surety, and prequalification capacity calculations), taxes, budgeting, controls and processes, information technology requirements, and accounting. Entities will apply the new revenue standard in the first interim period within annual reporting periods beginning on or after 15 December 2016 (US GAAP) and 1 January 2017 (IFRS). Earlier adoption is permitted under IFRS, but not under US GAAP. For non-public entities (US GAAP only), the standard is effective for annual reporting periods beginning after 15 December 2017 and for interim reporting periods within annual reporting periods beginning after 15 December Earlier application is permitted for non-public entities; however, no earlier than 15 December Entities can adopt the final standard retrospectively or use a simplified approach. Entities using the simplified approach will: (a) apply the revenue standard to all existing contracts as of the effective date and to contracts entered into subsequently; (b) recognise the cumulative effect of applying the new standard in the opening balance of retained earnings on the effective date; and (c) disclose, for existing and new contracts accounted for under the new revenue standard, the impact of adopting the standard on all affected financial statement line items in the period the standard is adopted. An entity that uses this approach must disclose this fact in its financial statements. About PwC s Engineering & Construction practice Our Engineering & Construction practice comprises more than 5,800 highly skilled professionals who serve 20,000+ engineering and construction companies around the world. We specialise in providing tailored advisory solutions as well as assurance and tax services to contractors, house builders, building products companies, professional and support services companies, and governments, as well as private and public sector companies. PwC helps organisations and individuals create the value they re looking for. We re a network of firms in 157 countries with more than 184,000 people who are committed to delivering quality in assurance, tax and advisory services. For more information, please contact: H. Kent Goetjen US Engineering and Construction Leader Phone: +1 (860) h.kent.goetjen@us.pwc.com Jonathan Hook Global Engineering and Construction Leader Phone: +44 (0) jonathan.hook@uk.pwc.com These materials were downloaded from Inform ( under licence.page 47 / 307

48 1 This guidance is included in ASC Topic , Construction-Type and Production-Type Contracts (U.S. GAAP), and International Accounting Standards 11, Construction Contracts (IFRS). Industrial products and manufacturing industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for entities in the Industrial Products sector as they transition to the new standard. These areas include, but are not limited to, contract combinations and contract modifications, transfer of control, and contract costs. Other supplements present the impact of the new standard in other industrial sectors, including Aerospace and Defence, and Engineering and Construction. Overview The FASB and IASB developed a single, comprehensive revenue recognition model for all contracts with customers to achieve greater consistency in the recognition and presentation of revenue. The model in the new standard is based on changes in contract assets (rights to receive consideration) and liabilities (obligations to provide a good or perform a service). Revenue is recognised based on the satisfaction of performance obligations, which occurs when control of a good or service transfers to a customer. The Industrial Products (IP) sector comprises a range of entities involved in the production of goods and delivery of services across a diverse industry base. This includes industrial manufacturing, metals, chemicals, and forest, paper and packaging entities. Although each industry in the IP sector has different product and service offerings, there are a number of common revenue recognition issues. Management of IP entities should carefully assess the new standard to determine the extent of its impact on their businesses. Identifying the contract with the customer An IP entity may enter into multiple contracts with the same customer at the same time. These contracts may include products that will not be provided directly by the IP entity entering into the contract. The contracts could also be affected by subsequent modifications (such as change orders). New standard Current US GAAP Current IFRS Contract combinations Contracts entered into at or near the same time with the same customer need to be combined if one or more of the following criteria are met: Combining contracts is permitted provided certain criteria are met. Combining is not required as long as the underlying economics of the transaction are fairly reflected. Combining contracts is required when certain criteria are met. Cash paid to a customer is recorded as a reduction of revenue unless the cash is for These materials were downloaded from Inform ( under licence.page 48 / 307

49 The contracts are negotiated as a package with a single commercial objective. The amount of consideration to be paid in one contract depends on the price or performance of the other contract. The goods or services promised in the separate contracts are a single performance obligation. Promises to provide goods or services to the customer s customer can be performance obligations if they are identified in the contract. Cash paid to a customer is recorded as a reduction of revenue unless the cash is for the purchase of an identifiable good or service from the customer that is separate from the goods or services being provided by the entity. Impact both IFRS and US GAAP: the purchase of an identifiable good or service from the customer that is separate from the goods or services being provided by the entity. Current guidance under both IFRS and US GAAP requires that the contract be the unit of account, except when the criteria for combining contracts are met. The new standard provides criteria for combining contracts that are similar to existing guidance. Both frameworks also currently provide guidance on identifying and separately accounting for deliverables in an arrangement. The new guidance provides more detailed criteria that could result in the identification of more deliverables (performance obligations) than in the past. Entities that sell goods to a distributor, but promise additional goods or services directly to an end customer will need to allocate some of the transaction price in the contract to those goods and or services, even if they will be provided by a third party. Revenue is recognised when those goods or services are delivered. The accounting for cash paid to a customer is similar to today s requirements. Promises to pay cash to the customer, unless paid for a distinct good or service, are accounted for as reductions of the transaction price. New standard Current US GAAP Current IFRS Contract modifications A contract modification, including a contract claim, exists when the parties to the contract approve a change that creates or changes the enforceable rights and obligations of the parties. A modification only affects a contract once it is approved, which can be in writing, oral, or based on customary business practices. A change order is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. US GAAP includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be A change order (known as a variation) is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders. These materials were downloaded from Inform ( under licence.page 49 / 307

50 A contract modification is treated as a separate contract only if it results in the addition of a distinct performance obligation and the price is reflective of the stand-alone selling price of that additional performance obligation. If the above criteria are not met, the contract modification is accounted for as an adjustment to the original contract, either through a cumulative catch-up adjustment to revenue or a prospective adjustment to revenue when future performance obligations are satisfied, depending on whether the remaining performance obligations are distinct from those in the original contract. performed is defined, but the price is not). Impact both IFRS and US GAAP: Change orders are a common form of contract modification in the IP industry. Change orders will be treated as separate contracts under the new standard if they represent distinct performance obligations and the price reflects their stand-alone selling price. A good is distinct if the customer can benefit from it on its own (or with other readily available resources) and the entity s promise to transfer the good is separable from the other promises in the contract. If the goods or services in the modification are distinct from those transferred before the modification, but the price of the additional goods or services does not represent the current selling price of those goods or services, the change is considered a modification of the initial contract and should be recorded prospectively. A change order that affects a partially completed performance obligation will be accounted for through a cumulative catch-up adjustment at the date of the contract modification. Changes to only the transaction price will be treated like any other contract modification. As it will not result in a separate contract, the change in price will be either accounted for prospectively or on a cumulative catch-up basis, depending on whether the remaining performance obligations are distinct. Determining transfer of control and recognising revenue Many IP entities have contracts that include long-term manufacturing and may include a service (installation or customisation) along with the sale of products. The products and services may be delivered over a period ranging from several months to several years. New standard Current US GAAP Current IFRS Transfer of control Revenue is recognised upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time. Service revenue from transactions not specifically in the scope of contract accounting is recognised by applying either the proportional performance model or the completed contract model, depending on Revenue is recognised for transactions not in the scope of the contract accounting guidance once the following conditions are satisfied: The risk and These materials were downloaded from Inform ( under licence.page 50 / 307

51 A performance obligation is satisfied over time if any of the following criteria is met: The customer receives and consumes the benefits of the entity s performance as the entity performs. The entity s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. The entity s performance does not create an asset with alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. A performance obligation is satisfied at a point in time if it does not meet one of the criteria above. Determining the point in time when control transfers will require judgement. Indicators that should be considered in determining whether the customer has obtained control of a good include: The entity has a right to payment. the specific facts. For transactions in the scope of construction-type and production-type contract guidance (ASC ), revenue is recognised using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall loss), the percentage-of-completion method based on a zero profit margin is used until more precise estimates can be made. The completed-contract method is required when reliable estimates cannot be made. Impact both IFRS and US GAAP: rewards of ownership have transferred. The seller does not retain managerial involvement to the degree usually associated with ownership nor retain effective control. The amount of revenue can be reliably measured. It is probable that the economic benefit will flow to the entity. The costs incurred can be measured reliably. Revenue is recognised for transactions in the scope of contract accounting, using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made but it is probable that no loss will be incurred on a contract (for example, when the scope of the contract is illdefined, but the contractor is protected from an overall loss), the percentage-of-completion method based on a zero profit margin is used until moreprecise estimates can be made. The completed contract method is not permitted. Management will need to apply judgement to assess the criteria for whether performance obligations are satisfied over time, These materials were downloaded from Inform ( under licence.page 51 / 307

52 The customer has legal title. The customer has physical possession. The customer has the significant risks and rewards of ownership. The customer has accepted the asset. especially whether assets have an alternative use and whether the entity has a right to payment for performance completed to date. Depending on facts and circumstances, entities that are using construction-type accounting under IFRS may have to recognise revenue at a point in time. This is a change compared to current IFRS guidance which, unlike US GAAP, does not allow entities to use the completed contract method. Manufacturers of large volumes of homogeneous goods produced to a customer s specification could meet the criteria for recognition over time when (1) such goods have no alternative use given they are highly customised or if they contractually cannot be redirected to another party, and (2) the payment terms provide that the customer will reimburse costs incurred plus a reasonable profit margin for both completed units and those in production at any point of time. This could result in revenue being recognised earlier than under current guidance. Measuring progress for performance obligations satisfied over time Methods for recognising revenue when control transfers over time include: input methods that recognise revenue on cost incurred, labour hours expended, time lapsed, or machine hours used; and output methods that recognise revenue based on units produced or delivered, contract milestones, or surveys of work performed. Outputs used to measure progress may not be directly The use of a proportional performance model based upon cost-to-cost measures is generally not appropriate for transactions outside the scope of contract accounting. Entities applying contract accounting use either an input method (for example, cost-tocost, labour hours, labour cost, machine hours, material quantities), an output method (for example, physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage complete is determined (using the appropriate measure of progress), there are two different approaches for determining revenue, costs of revenue, and gross profit: the Revenue method or the Gross Profit method. Impact both IFRS and US GAAP: Service revenue from transactions not in the scope of contract accounting is recognised based on the stage of completion if the transaction s outcome can be estimated reliably. Entities applying contract accounting can use either an input method (for example, cost-to-cost, labour hours, labour cost, machine hours, material quantities), an output method (for example, physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage complete is determined (using the appropriate measure of progress), IFRS requires the use of the Revenue method to determine revenue, costs of revenue, and gross profit. The Gross Profit method is not permitted. These materials were downloaded from Inform ( under licence.page 52 / 307

53 observable and the information to apply them may not be available without undue cost. In such cases an input method may be necessary. Output methods such as units produced or units delivered may not faithfully depict an entity s performance if at the end of the reporting period the value of work-in-progress or finished goods controlled by the customer is material or if the contract provides both design and production services. In such cases, each item produced or delivered may not transfer an equal amount of value to the customer. The new standard allows both input and output methods for recognising revenue for performance obligations that are satisfied over time. Management should select the method that best depicts the transfer of control of goods and services to the customer. Input methods should represent the transfer of control of the asset or service to the customer and should therefore exclude the costs of any activities that do not depict the transfer of control (for example, abnormal amounts of wasted labour or materials). Entities manufacturing large volumes of homogeneous products that meet the criteria for performance obligations satisfied over time will be required to recognise revenue as goods are produced rather than when they are delivered to the customers. This could be the case for certain contract manufacturers depending on the terms of the arrangements. The Gross Profit method of calculating revenue, costs of revenue, and gross profit based on the percentage complete will no longer be acceptable under the new standard, which is a change from current US GAAP. Methods used under IFRS are likely to be acceptable under the new standard. Example 1 Facts: A vendor enters into a contract to produce a significantly customised product for a customer. Management has determined that the contract is a single performance obligation. The contract has the following characteristics: The customisation is significant and customer s specifications may be changed at the customer s request during the contract term. Non-refundable, interim progress payments are required to finance the contract. The customer can cancel the contract at any time (with a termination penalty) and any work in process has no alternative use to the vendor. Physical possession and title do not pass until completion of the contract. How should the vendor recognise revenue? Discussion: The terms of the contract, in particular the customer specifications (and ability to change the specifications) indicate that the work in process has no alternative use to the vendor, and the non-refundable progress payments suggest that control of the product is being transferred over the contract term. Revenue is therefore recognised over time as the products are produced. Management will need to select the most appropriate measurement model (either an input or output method) to measure the revenue arising from the transfer of control of the product over time. Example 2 Facts: A vendor enters into a contract to construct several products for a customer. Management has determined that the contract is a single performance obligation. The contract has the following characteristics: The majority of the payments are due after the products have been installed. These materials were downloaded from Inform ( under licence.page 53 / 307

54 The customer can cancel the contract at any time (with a termination penalty) and any work in process remains the property of the vendor. The work in process can be completed and sold to another customer. Physical possession and title do not pass until completion of the contract. How should the vendor recognise revenue? Discussion: The terms of the contract, in particular payment upon completion and the inability of the customer to retain work in process, suggest that control of the products is transferred at a point in time. The vendor will not recognise revenue until control of the products has transferred to the customer. Example 3 Facts: A vendor enters into a contract to manufacture ten products for a customer. Management has determined that the contract is a single performance obligation satisfied over time. Each product takes a few weeks to be manufactured and during production the entity has significant work in process. How should the vendor recognise revenue? Discussion: The entity should apply a method that depicts the entity s performance to date, and that should not exclude a material amount of goods or services for which control has transferred to the customer. Given that the performance obligation is satisfied over time, control is transferred to the customer as the products are being manufactured. Since the work in process is always significant, using a units of-delivery or a units-of-production method will ignore the work in process that belongs to the customer. Therefore these methods may not be appropriate. An input method such as cost-to-cost is likely to better depict the transfer of control. Variable consideration The transaction price is the consideration the vendor expects to be entitled to in exchange for satisfying its performance obligations in an arrangement. Determining the transaction price may require judgement if the consideration contains an element of variable or contingent consideration. Common considerations in this area include the accounting for volume discounts, awards/incentive payments, claims, and significant financing components. Variable consideration is included in the transaction price only to the extent that it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the cumulative amount of revenue recognised will not occur in future periods if the estimates of variable consideration change. However, entities need to consider whether there is some minimum amount that is not subject to reversal, even if the total amount of variable consideration is not included in the transaction price. New model Current US GAAP Current IFRS Volume discounts Volume discounts represent variable consideration and are recognised as a reduction to revenue. Both a qualitative and a quantitative assessment need to be performed to determine if revenue is subject to a significant reversal. Factors that indicate that including an estimate of volume discounts in Volume discounts are recognised as a reduction to revenue as the customer earns the rebate. The reduction is limited to the estimated amounts potentially due to the customer. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential These materials were downloaded from Inform ( under licence.page 54 / 307 Volume discounts are systematically accrued based on discounts expected to be taken. The discount is then recognised as a reduction of revenue based on the best estimate of the amounts potentially due to the customer. If the discount cannot be reliably estimated,

55 the transaction price could result in a significant revenue reversal include, but are not limited to the following: The amount of consideration is highly susceptible to factors outside the entity s influence. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time. The entity s experience (or other evidence) with similar types of contracts is limited. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. The contract has a large number and broad range of possible consideration amounts. rebate. Impact both IFRS and US GAAP: revenue is reduced by the maximum potential rebate. ties will need to consider their experience with a client or with similar clients and other factors to determine what volume discounts are highly probable (IFRS) or probable (US GAAP) and what level of rebate should be deferred. The accounting for volume discounts may be different than under current US GAAP. Volume discounts are recognised as they are earned under current US GAAP. Under the new standard, these types of volume discounts represent an option that the customer receives, as it provides the customer with a right to a discounted product in the future. Revenue might have to be recognised later than today given that entities will need to defer a portion of revenue from sales occurring earlier in the arrangement and recognise it in conjunction with discounted sales in the future. Entities will need to consider the variable consideration guidance to ensure that revenue recognised for sales occurring earlier in the arrangement will not be subject to significant reversal in the future. The accounting under the new standard is similar to existing IFRS guidance. Customer options to acquire additional goods or services for free or at a discount come in many forms, including sales incentives, customer award credits (or points), contract renewal options or other These materials were downloaded from Inform ( under licence.page 55 / 307

56 discounts on future goods or services. Awards/Incentive payments/claims Same as for volume rebates above. Awards/incentive payments are included in contract revenue (under the scope of construction-type and production-type contract accounting) when the specified performance standards are probable of being met and the amount can be reliably measured. A claim is recorded for contracts under the scope of construction-type and production-type contract accounting as contract revenue only if it is probable and can be reliably estimated, which is determined based on specific criteria. Claims meeting these criteria are only recorded to the extent of contract costs incurred. Profits on claims are not recorded until they are realised. Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met and the amount can be reliably measured. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured. Significant financing component An entity will adjust the amount of promised consideration to reflect the time value of money if the contract includes a significant financing component. Interest income will need to be separately presented from the sale of goods or services. When discounting is required, the discount rate should reflect a separate financing transaction between the entity and its customer and also factor in credit risk. Impact both IFRS and US GAAP: Accounting for awards, incentive payments and claims is likely to be similar under the new standard compared to today s accounting (IFRS and US GAAP). The discounting of revenues is required in only limited situations, including receivables with payment terms greater than one year. When discounting is required, the interest component is computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable. Impact both IFRS and US GAAP: Discounting of revenues to present value is required in instances where the effect of discounting is material. An imputed interest rate is used in these instances for determining the amount of revenue to be recognised, as well as the separate interest income component to be recorded over time. The new standard is not significantly different than today s These materials were downloaded from Inform ( under licence.page 56 / 307

57 As a practical expedient, an entity is not required to reflect the effects of a significant financing component when the time period between payment and performance is less than one year. guidance. We do not expect a significant change to current practice for most IP and manufacturing entities in connection with the existence of a significant financing component, because payment terms often do not extend more than one year from the time of contract performance. An entity paid in advance for goods or services need not reflect the effects of time value of money when: the transfer of those a. goods or services to the customer is at the discretion of the customer; if a substantial b. amount of the consideration promised by the customer is variable and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event not substantially in the control of the customer or the entity; or the difference c. between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance to either the customer or the entity, and the difference between the two is proportional to the reason for the difference. Example #4 Facts: A chemical entity has a one-year contract with a car manufacturer to deliver high These materials were downloaded from Inform ( under licence.page 57 / 307

58 performance plastics. The contract stipulates that the chemical entity will give the car manufacturer a rebate when certain levels of future sales are reached, according to the following scheme: Rebate Sales Volume 0% 0-10,000,000 lbs 5% 10,000,001-30,000,000 lbs 10% 30,000,001 lbs and above The rebates are calculated based on gross sales in a calendar year and paid at the end of the first quarter of the following year. Based on past experience and expected car sales for the year, management believes that the most likely rebate that it will have to pay is 5%. How does the chemical entity recognise revenue? Discussion: The entity has experience with similar types of contracts with this client. Considering that experience and its expectation of car sales for the year, management recognises revenue based on the amount not expected to be subject to significant reversal. So 95% of the transaction price is recognised as goods are provided to the car manufacturer. This estimate is monitored and adjusted, as necessary, using a cumulative catch-up approach. Contract costs IP entities frequently incur costs prior to finalising a contract. Costs to obtain or fulfil a contract may include engineering set-up costs, pre-contract planning and design costs, and sales commissions. New standard Current US GAAP Current IFRS Incremental costs to obtain a contract should be recognised as an asset if they are expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained (for example, sales commissions). They can include costs incurred before the contract is obtained if those costs relate to an anticipated contract that the entity can specifically identify. An entity is permitted to expense contract acquisition costs as incurred as a practical expedient for contracts with a duration of one year or less. Direct costs incurred to fulfil a contract are first assessed to determine if they are within the scope of other standards (for example, inventory, There is detailed guidance on the accounting for contract costs that are under the scope of construction-type and production-type contract guidance (ASC ). Pre-contract costs that are incurred for a specific anticipated contract may be deferred only if the costs can be directly associated with a specific anticipated contract and if their recoverability from that contract is probable. Outside of contract accounting, there is limited guidance on the treatment of costs associated with revenue transactions. Certain types of costs incurred prior to revenue recognition may be capitalised if they meet the definition of an asset. Impact both IFRS and US GAAP: These materials were downloaded from Inform ( under licence.page 58 / 307 There is detailed guidance on the accounting for contract costs in construction contract accounting (IAS 11). Costs that relate directly to a contract and are incurred in securing that contract are included as part of contract costs that can be capitalised if they can be separately identified, measured reliably, and it is probable that the contract will be obtained. Costs associated with transactions that are not in the scope of contract accounting are capitalised if such costs are within the scope of other asset standards (for example, inventory, PP&E or intangible assets) or meet the definition of an asset in the Conceptual Framework.

59 intangibles, fixed assets), in which case the entity should account for such costs in accordance with those standards (either capitalise or expense). If they are not in the scope of other guidance, they should be evaluated under the revenue standard. An entity recognises an asset only if the costs relate directly to a contract, generate or enhance resources that relate to future performance, and are expected to be recovered. Costs related to inefficiencies (for example, abnormal costs of materials, labour, or other costs to fulfil) should be expensed as incurred. Incremental costs to obtain a contract as well as fulfilment costs are amortised in a manner consistent with the pattern of transfer of the goods or services to which the asset relates. Costs likely to be in the scope of this guidance include, among others, sales commissions, set-up costs for service providers, and costs incurred in the design phase of construction projects. Cost to fulfil a contract can also include training costs. Under current IFRS, training costs typically cannot be capitalised as they do not meet the definition of an asset. As the trained employees can leave at any time, the manufacturer does not control the benefit associated with the training. Training costs are not covered specifically under current US GAAP guidance and there is therefore a policy choice on expensing versus capitalising. The impact on entities will vary depending on the guidance and policies followed currently. However, policy elections on whether to capitalise or expense costs will no longer be permitted, except as it relates to the practical expedient for costs to obtain a contract with a duration of one year or less. Example #5 Facts: A salesperson earns a 5% commission on a contract that was signed during January 20X1. The products purchased in the contract will be delivered throughout the next year. How should the entity account for the commission paid to its employee? Discussion: The commission payment should be capitalised as it represents a cost of obtaining the contract. However, in this example, as a practical expedient, the commission can be expensed as incurred since the commission relates to a contract that extends one year or less. Example #6 Facts: A manufacturer incurs upfront contract costs at the beginning of a long-term production contract. These upfront costs include the training of employees, setting up the factory for production, and non-recurring engineering costs related to the production equipment. How should these costs be accounted for? Discussion: Training costs will likely be expensed as incurred under the new standard. Only those costs that generate or enhance resources used to satisfy performance obligations in the future can be capitalised. Training of employees is unlikely to generate or enhance resources of the entity, and therefore do not meet the criteria for capitalisation. Demonstrating that training costs relate to future performance obligations might be difficult and may result in some of those costs being expensed as incurred. The costs of setting up the factory and engineering should first be assessed to determine if they These materials were downloaded from Inform ( under licence.page 59 / 307

60 should be capitalised under fixed asset guidance. Those costs and any other upfront contract costs incurred which are not covered by existing fixed asset standards should be assessed to determine if they (a) relate directly and exclusively to this specific contract; (b) generate or enhance resources of the entity that will be used for the production, and (c) are probable of recovery. Costs that meet all three criteria are capitalised and then amortised over the contract period as control of the goods produced is transferred to the customer. Collectability Collectability refers to the risk that the customer will not pay the promised consideration. The new model includes a collectability threshold for determining whether a transaction is in the scope of the revenue guidance. New model Current US GAAP Current IFRS To be in the scope of the new standard, an entity needs to conclude at the inception of the contract that collectability is probable. The term probable has different meanings under IFRS and US GAAP. Revenue from an arrangement is deferred in its entirety if an entity cannot conclude that collection from the customer is reasonably assured. The collectability assessment is based on both the customer s ability and intent to pay as amounts become due. The assessment of collectability should be made after considering any price concessions that the entity might provide to the customer. When a contract with a customer does not meet the collectability threshold and the entity receives consideration from the customer, the entity shall recognise the consideration received as revenue only when either: the entity has no a. remaining obligations to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable; or Credit risk is reflected as a reduction of accounts receivable by recording an increase in the allowance for doubtful accounts and bad debt expense. Impact both IFRS and US GAAP: An entity must establish that it is probable that the economic benefits of the transaction will flow to the entity before revenue can be recognised. A provision for bad debts (incurred losses on financial assets including accounts receivable) is recognised in a two-step process: (1) objective evidence of impairment must be present; then (2) the amount of the impairment is measured based on the present value of expected cash flows. The inclusion of a collectability threshold is not a significant change to current guidance. An arrangement that does not meet the collectability threshold does not meet the criteria to be a contract in the scope of the new revenue standard. An entity that receives consideration from a customer in an arrangement that does not meet the collectability threshold will likely not recognise revenue for that consideration as it is received from the customer, even if it is non-refundable. In other words, an arrangement that does not meet the collectability threshold does not default to cash basis accounting. Any consideration received is recorded as a liability until there are no remaining performance obligations and all or most of the consideration has been received or the contract is terminated and any consideration that has been received is non-refundable. This could result in revenue being recorded later than under current guidance in some situations. These materials were downloaded from Inform ( under licence.page 60 / 307

61 the contract has b. been terminated and the consideration received from the customer is nonrefundable. An entity shall reassess throughout the contract period whether (a) an arrangement that did not meet the collectability threshold subsequently meets that threshold and therefore should be accounted for under the revenue standard, or (b) there is an indication of a significant change in facts and circumstances relating to a contract that initially met the collectability threshold. Initial and subsequent impairment should be presented prominently as an expense below gross margin. Principal versus agent IP entities may involve third parties when providing goods and services to their customers. Management needs to assess whether the entity is acting as the principal or an agent in such arrangements. New model Current US GAAP Current IFRS An entity recognises revenue on a gross basis if it is the principal in the arrangement, and on a net basis (that is, equal to the commission received) if it is acting as an agent. Specific indicators are provided for entities to consider when assessing whether the entity is the principal or the agent in an arrangement. An entity is the principal in an arrangement if it obtains control of the goods or services of another party in advance of transferring control of those goods or services to a customer. The entity is an agent if its performance obligation is to arrange for another party to provide the goods or services. Indicators that the entity is an Revenue is recognised net (for example, based on the amount of the commission) in an agency relationship. Impact both IFRS and US GAAP: Specific indicators are provided for entities to consider when assessing whether the entity is the principal or the agent in an arrangement. Revenue is recognised net (for example, based on the amount of the commission) in an agency relationship. The indicators of a principal or agent relationship are similar to the current guidance in IFRS and US GAAP. The guidance does not weigh any of the indicators more heavily than others, similar to IFRS. Under existing US GAAP, some indicators carry more weight (for example, the entity is the primary obligor, has general inventory risk, and latitude in establishing These materials were downloaded from Inform ( under licence.page 61 / 307

62 agent include: The other party has primary responsibility for fulfilment of the contract (that is, the other party is the primary obligor). The entity does not have inventory risk. The entity does not have discretion in establishing prices. The entity does not have customer credit risk. The entity s consideration is in the form of a commission. price). Regardless, we do not expect a significant change in practice for many industrial products and manufacturing entities. However, the criteria should be carefully considered to determine if control of a good or service passes to an entity before it is transferred to a customer. Warranties Many IP entities provide standard warranties with their products that can be effective for a number of years. A standard warranty is given to all customers and protects against defects for a specific time period. Many entities also offer extended warranties or sell warranties separately that provide for coverage beyond the standard warranty period. New model Current US GAAP Current IFRS An entity will account for a warranty as a separate performance obligation if the customer has the option to purchase the warranty separately. An entity will account for a warranty as a cost accrual if it is not sold separately unless the warranty is to provide the Entities typically account for standard warranties protecting against latent defects in accordance with existing loss contingency guidance. An entity recognises revenue and concurrently accrues any expected costs for these warranty repairs. Separately priced extended These materials were downloaded from Inform ( under licence.page 62 / 307 Entities typically account for standard warranties protecting against latent defects in accordance with existing provisions guidance. An entity recognises revenue and concurrently accrues any expected cost for these warranty repairs. Revenue from the sale of

63 customer with a distinct service. If a part of a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the entity should account for that part of the warranty as a performance obligation. A warranty that provides both assurance and services should be accounted for as a service if the entity is unable to distinguish the assurance portion from the service portion. warranties result in the deferral of revenue based on the contractual price of the extended warranty. The value deferred is amortised to revenue over the extended warranty period. Impact both IFRS and US GAAP: extended warranties is deferred and recognised over the period covered by the warranty. Warranties that are sold separately are separate performance obligations for which revenue is recognised over the warranty period, similar to the accounting treatment under existing guidance. Under US GAAP, the value ascribed to warranties that are separately priced may be affected as the arrangement consideration will be allocated on a relative stand-alone selling price basis rather than at the contractual price under current guidance. As a result, the amount of revenue deferred for extended warranties might differ under the new standard compared to current guidance. The new standard should not change current practice under IFRS. Example #7 Facts: An entity sells a product which includes a 90-day standard warranty. The entity will replace defective components of the product under the standard warranty. The warranty does not provide an additional service to the customer. How does the entity account for such a warranty? Discussion: The entity should account for the warranty as a cost accrual, similar to today s guidance. Example #8 Facts: An entity sells a product which includes a 90-day standard warranty. Customers can also purchase a separate warranty that provides for an additional 18 months of coverage. How does the entity account for such a warranty? Discussion: The standard warranty is accounted for in the same manner as the standard warranty offered in Example 7 above because it is not sold separately and does not provide an additional service. Similar to current guidance under both IFRS and US GAAP, the warranty sold separately is accounted for as a separate performance obligation. Management will allocate the transaction price (that is, contract revenue) to the product and the extended warranty based on their relative stand-alone selling prices. Revenue allocated to the extended warranty would be recognised over the warranty coverage period (starting on day 91 through the following 18 months). About PwC s Industrial Products practice PwC s Industrial Products practice provides financial, operational, and strategic services to global organisations across the Aerospace & Defence, Business Services, Chemicals, Engineering & Construction, Forest, Paper, & Packaging, Industrial Manufacturing, Metals, and Transportation & Logistics industries. These materials were downloaded from Inform ( under licence.page 63 / 307

64 Pharmaceutical and life sciences industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement discusses some of the more significant impacts to entities within the pharmaceutical and life sciences industry. Overview The pharmaceutical and life sciences industry includes a number of sub-sectors, the largest being pharmaceuticals, biotechnology, contract research organisations, and medical devices. The common feature is that each sub-sector develops, produces, and markets a diverse array of products, technologies, and services that relate to human health. Revenue recognition issues arise not only from the sale of drugs and medical devices, but increasingly from arrangements between entities in the industry to develop and bring products to market. Entities in the pharmaceutical and life sciences industry often enter into arrangements to develop drugs, either as a supplier of services, a consumer of those services, or through execution of licence arrangements. These complex transactions are impacted by the new revenue standard. This supplement focuses on how the standard will impact entities in the pharmaceutical and life sciences industry and it contrasts the new revenue standard with current practice under IFRS and US GAAP. The examples and related discussions are intended to provide areas of focus to assist entities in evaluating the implications of the new standard. Scope While specific contracts with customers are scoped out of the new standard (for example, lease contracts, insurance contracts, financial instruments, guarantees excluding warranties, and certain non-monetary exchanges), the standard applies to just about all contracts with customers. A customer is defined as 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. The standard does not apply to contracts where the parties participate in an activity or process (such as developing an asset in a collaboration agreement) and both parties share in the risks and benefits that result from the activity or process. One challenge for entities in the pharmaceutical and life sciences industry will be evaluating their collaboration arrangements to determine if those arrangements represent contracts with customers. A contract that might be outside the scope of the standard is one with a collaborator or partner with shared risks and benefits in developing a product, because it is not for the sale of goods or services that are an output of the entity s ordinary activities. For example, an agreement between a biotechnology entity and pharmaceutical entity to share equally in the risks and benefits associated with development of a specific drug is likely not in the scope of the standard if the parties have a collaborative relationship rather than a vendor-customer relationship. If, however, the substance of the arrangement is that the biotechnology entity is licensing its IP or selling its compound to the pharmaceutical entity and/or providing research These materials were downloaded from Inform ( under licence.page 64 / 307

65 and development ( R&D ) services, it will likely be in scope if such activities result in a good or service that is an output of the biotechnology entity s ordinary activities. Determining whether an arrangement is in the scope of the revenue standard is complex. Arrangements may contain elements of a customer relationship and elements of a collaborator relationship. When analysing arrangements, entities should identify the activities of the parties, understand the risks and benefits resulting from the activities, and determine if the parties are sharing in those risks and benefits. It will also be important to determine which party receives goods or services and whether those goods or services represent an output of the ordinary activities of the delivering party. For those contracts, such as collaboration arrangements, that include some components that are in the scope of the revenue standard and other components that are in the scope of other standards, an entity will first apply the separation and/or measurement guidance in the other standard, if any. The transaction price will be reduced by the portion initially measured by the other standard(s) and the revenue standard will apply to the remaining transaction price. For example, an entity might lease a medical device to its customer and also provide related training services and consumables. In this arrangement, the lease is subject to lease accounting while the other components (training services and consumables) are subject to the revenue standard. Licences and rights to use Generally, a licence granted by an entity (the licensor) provides the customer (the licensee) with the right to use, but not own, the licensor s intellectual property ( IP ). A common example in the pharmaceutical and life sciences industry is an entity that out-licenses to a customer the IP it developed related to a drug that has not yet received regulatory approval. Often, under the terms of the licence, the licensee can further develop the IP, and manufacture and/or sell the resulting commercialised product. The licensor typically receives an upfront fee, milestone payments for specific clinical outcomes, and sales-based royalties as consideration for the licence. Some arrangements also include ongoing involvement by the licensor, who might provide R&D or manufacturing services relating to the licensed technology. Accounting for licences could be challenging under the new revenue standard. Determining whether a licence is distinct from other goods and services in an arrangement is a key part of applying the model. Licences coupled with other services, such as R&D, must first be assessed to determine if the licence is distinct. If the licence is not distinct, then the licence is combined with other goods or services into a single performance obligation. Revenue is recognised as the licensor satisfies the combined performance obligation. Distinct licences fall into one of two categories: (1) rights to use IP or (2) access rights. The accounting for each category of licence is described in the chart below. New standard Current US GAAP Current IFRS There are two types of licences described in the new standard. The first is a licence that provides a customer the right to use an entity s IP as it exists at the point in time the licence is granted. For these licences, revenue is recognised at a point in time when control transfers to the licensee and the licence period begins. These licences provide the customer with a Consideration is allocated to the licence and revenue is recognised when earned, typically when the licence is transferred if the licence has stand-alone value. If the licence does not have stand-alone value, the licence is combined with other deliverables, typically R&D or manufacturing services into a single unit of account. Revenue for the single unit of account is recognised when These materials were downloaded from Inform ( under licence.page 65 / 307 Fees and royalties received for the use of an entity's assets (such as trademarks, patents, record masters and motion picture films) are normally recognised in accordance with the substance of the agreement. As a practical matter, this may be on a straight-line basis over the life of the agreement, for example, when a licensee has the right to use certain IP or technology for a specified period of time.

66 right to IP and the IP does not change after the licence transfers to the customer. The second type is a licence that provides access to an entity s IP as it exists throughout the licence period. Licences that provide access are performance obligations satisfied over time and, therefore, revenue is recognised over time. A licence provides access to an entity s IP if three criteria are met: earned, typically as the R&D or manufacturing services are performed. An assignment of rights for a fixed fee that permits the licensee to exploit those rights freely is, in substance, a sale if the licensor has no remaining obligations. Determining whether a licence is a sale requires the use of judgement. When a licence is sold with services or other deliverables, the vendor is required to exercise judgement to determine whether the different components of the arrangement should be accounted for separately. The licensor will undertake (either contractually or based on customary business practice) activities that significantly affect the IP to which the customer has rights. The licensor s activities do not otherwise transfer a good or service to the customer as they occur. The rights granted by the licence directly expose the customer to any effects (both positive and negative) of those activities on the IP and the customer entered into the contract These materials were downloaded from Inform ( under licence.page 66 / 307

67 with the intent of being exposed to those effects. If a licensing arrangement includes multiple goods or services (such as a licence of IP and R&D services), an entity needs to consider whether the licence is distinct. If not, it should be combined with other goods or services into a single performance obligation. 1 Revenue is recognised as the entity satisfies the combined performed obligation. In order for the licence to be considered distinct, the customer must be able to benefit from the IP on its own or together with other resources that are readily available to the customer, and the entity s promise to transfer the IP must be separately identifiable from other promises in the contract. The new revenue standard provides indicators that assist in determining whether the IP is separately identifiable from other promises in the contract. Revenue cannot be recognised before the beginning of the period during which the customer can use and benefit from the licensed IP, notwithstanding when the licence is transferred. Impact: In general, we believe the revenue standard will not have a significant impact on revenue recognition for those licensing arrangements involving a licence to IP for the life of the underlying asset in exchange for only an up-front cash payment. However, the terms of the contract, the rights granted to the licensee, and the activities the licensor undertakes that significantly impact the IP will impact whether revenue should be recognised at a point in time or over time. A shared economic interest, such as a sales-based royalty, between a licensor and the licensee, might indicate that the licensor will undertake activities that benefit the licensee over the licence period. These materials were downloaded from Inform ( under licence.page 67 / 307

68 Revenue might not be recognised immediately upon transfer of the right for more complex licensing arrangements that include other deliverables such as R&D services, manufacturing services, or arrangements in which the licensor undertakes activities that significantly impact the underlying IP. Guarantees that the patent to the IP is valid and actions to defend that patent from unauthorised use are not considered activities that significantly impact the underlying IP. When licences are sold with R&D services, the stage of the research on the licensed technology could affect the assessment of whether the licence is distinct. For example, certain biotechnology entities do not sell licences without R&D services for early-stage products. During the discovery stage, an entity may have specialised know-how and technology such that it is the only entity able to provide the R&D services to the customer for the specific licensed product. In this fact pattern, the licence might not be a separate performance obligation because the customer cannot benefit from the licence without the R&D services and neither the customer nor other third parties have the necessary skills to perform the R&D services. If the licence is not distinct, the licence and the R&D services should be combined and accounted for as a single performance obligation. The total transaction price is recognised as revenue as the performance obligation is satisfied over the period R&D services are performed. In addition, because the licence is combined with the R&D services, the entity might no longer qualify for the exception provided to licences of IP when determining if sales- or usage-based royalties are excluded from variable consideration. Refer to the Royalties section of this supplement for more information. Another scenario is an arrangement that includes a licence of IP and R&D services that involve clinical development activity or clinical trials. In the pharmaceutical and life sciences industry, it is often possible for others to perform clinical development activity or clinical trials. The licence and the R&D services might be distinct in this fact pattern if the entity s promise to transfer the IP is separately identifiable from the R&D services. This is because the licensee could benefit from the licence on its own, and could choose to either perform or outsource the clinical trials. In this case, the transaction price is allocated to the two performance obligations on a relative stand-alone selling price basis, and revenue is recognised as each performance obligation is satisfied. The licence of IP would need to be evaluated to determine (1) if it provides the customer with the right to use the IP (with revenue recognised upon commencement of the licence) or provides access to the IP (with revenue recognised over time) and (2) whether consideration includes sales- or usage-based royalties for which the exception for variable consideration would be applicable. Complex licensing arrangements will require careful consideration to determine whether the performance obligations should be accounted for separately. Entities will need to use judgement in evaluating the criteria and indicators in the standard to ensure that combining or separating goods and services results in accounting that reflects the underlying economics of the transaction. Variable consideration and the constraint on revenue recognition Variable consideration includes payments in the form of milestone payments, royalties, rebates, price protection, and other discounts and incentives. Common examples of arrangements with variable consideration in the pharmaceutical and life sciences industry include licensing arrangements with milestone payments and sales-based royalties, and distributor arrangements with rebates, price protection, or other incentives. Under the new revenue standard, the transaction price is the amount of consideration an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. The transaction price, at the inception of the arrangement, might include an element of consideration that is variable or contingent upon the outcome of future events. If the promised amount of consideration in a contract is variable, an entity should estimate the total transaction price. This estimate can be based on either the expected value (probabilityweighted estimate) or the most likely amount of cash flows expected from the transaction, These materials were downloaded from Inform ( under licence.page 68 / 307

69 whichever is more predictive. The estimated transaction price should be updated at each reporting date to reflect the current facts and circumstances. The estimate of variable consideration is subject to a constraint. The objective of the constraint is that an entity should recognise revenue as performance obligations are satisfied to the extent there will not be a significant reversal in the future when the uncertainty is subsequently resolved. An entity will meet this objective if it is highly probable (IFRS) or probable (US GAAP) that there will not be a significant revenue reversal in future periods. Such a reversal would occur if there is a significant downward adjustment of the cumulative amount of revenue recognised for a specific performance obligation. Entities will need to apply judgement to determine if variable consideration is subject to a significant reversal. The following indicators might suggest that variable consideration could result in a significant reversal of cumulative revenue recognised in the future: The amount of consideration is highly susceptible to factors outside the influence of the entity. Resolution of the uncertainty about the amount of consideration is not expected for a long period of time. The entity has limited experience with similar types of contracts. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions in similar circumstances for similar contracts. The contract has a large number and broad range of possible consideration amounts. Entities will need to determine if there is a portion of the variable consideration (that is, a minimum amount) that will not result in a significant revenue reversal. That amount will be included in the estimated transaction price. The estimate will be reassessed each reporting period, including any estimated minimum amounts. Milestone payments New standard Current US GAAP Current IFRS Milestone payments generally represent a form of variable consideration as the payments are likely to be contingent on future events. Milestone payments are estimated and included in the A substantive milestone is defined in ASC , Revenue Recognition Milestone Method, and can include milestone payments received upon achievement of certain events such as the transaction price based on submission of a new drug either the expected value application to the regulator or (probability-weighted approval of a drug by the estimate) or most likely regulator. amount approach. The most likely amount is likely to be most predictive for milestone payments with a binary outcome (that is, the entity receives all or none of the milestone payment). Allocating milestone payments An entity that uses the milestone method recognises revenue from substantive milestone payments in the period the milestone is achieved. Non-substantive milestone payments that are paid based on the passage of time or as a result of the licensee s performance are These materials were downloaded from Inform ( under licence.page 69 / 307 Milestone payments received for a licence with no further performance obligations on the part of the licensor are recognised as income when they are receivable under the terms of the contract and their receipt is probable. The milestone method is often an appropriate method of accounting if it approximates the percentage of completion of the services under the arrangement. The milestone events must have substance, and they must represent achievement of specific defined goals. Management should consider the following factors to determine when milestone

70 The transaction price is allocated to separate performance obligations based on relative stand-alone selling prices. If the transaction price includes consideration that is contingent upon a future event or circumstance (for example, the completion of a phase III clinical trial), the entity should allocate that contingent amount (and subsequent changes to the amount) entirely to one performance obligation if both of the following criteria are met: The contingent payment terms for the milestone relate specifically to the entity s efforts to satisfy that performance obligation or to a specific outcome from satisfying that separate performance obligation. Allocating the contingent amount entirely to the separate performance obligation reflects the amount of consideration to which the entity expects to be entitled in exchange for satisfying the performance obligation when allocated to the units of accounting within the arrangement and recognised as revenue when those deliverables are satisfied. An entity that does not use the milestone method may use other revenue recognition models to recognise milestone payments (such as the contingency adjusted performance model). These materials were downloaded from Inform ( under licence.page 70 / 307 payments are recognised as revenue: The reasonableness of the milestone payments compared to the effort, time and cost to achieve the milestones. Whether a component of the milestone payments relates to other agreements or deliverables. The existence of cancellation clauses requiring the repayment of milestone amounts received under the contract. The risks associated with achievement of the milestones. Obligations under the contract that must be completed to receive payment or penalty clauses for failure to deliver.

71 considering all of the performance obligations and payment terms in the contract. Recognising milestone income Variable consideration is only recognised as revenue when the related performance obligation is satisfied and the entity determines that it is highly probable (IFRS) or probable (US GAAP) that there will not be a significant reversal of cumulative revenue recognised in future periods. Entities will need to apply judgement to assess whether the amount of revenue recognised is subject to a significant reversal in the future. Impact: Current practice under IFRS and US GAAP is to recognise revenue upon meeting a probability threshold or achieving a certain outcome. Under the new standard, revenue will be recognised on contingent milestones when the performance obligation is satisfied and the entity determines that it is highly probable (IFRS) or probable (US GAAP) that there will not be a significant reversal of revenue in future periods. Entities will need to evaluate each milestone in a contract to determine whether including an estimate of variable consideration in the transaction price could result in a significant reversal of revenue in the future. For example, an entity might recognise the variable amount prior to achieving a milestone when the milestone relates to the completion of a specific service, and the entity has an established history of providing the service in similar contracts without a significant revenue reversal. This might be the case for a contract research organisation performing clinical trial related functions, such as enrolling and testing patients. On the other hand, milestones based on a specific clinical outcome are highly susceptible to factors outside the control of the entity, such as clinical trial results and regulatory approval. Entities may conclude that amounts related to these types of milestones are subject to significant revenue reversal in the future. Royalties New standard Current US GAAP Current IFRS Royalty revenue is a form of variable consideration and Royalties are recognised as they are earned and when Revenue from royalties accrues in accordance with the terms of therefore will be estimated collection is reasonably the relevant agreement and is using either the expected assured. Royalty revenue is usually recognised on that value (probability-weighted generally recorded in the basis unless it is more estimate) or most likely same period as the sales that appropriate to recognise These materials were downloaded from Inform ( under licence.page 71 / 307

72 amount approach. Estimated royalties are included in the transaction price if it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of cumulative revenue recognised will not occur in future periods. Entities will need to determine if there is a portion of the variable consideration (that is, a minimum amount) that will not result in a significant cumulative revenue reversal, and should be included in the transaction price. generate the royalty payment. revenue on some other systematic basis. There is a specific exception for licences of IP with consideration that varies entirely based on the customer s subsequent sales or usage of the IP (for example, a sales- or usagebased royalty). For these licences, the consideration is not included in the transaction price until it is no longer variable (that is, when the customer s subsequent sales or usages occur). This exception is limited to licences of IP with sales- or usagebased royalties and does not apply to other royalty arrangements. Impact: The new standard contains a limited exception for variable consideration related to sales- or usage-based royalties from licences of IP. These royalties are not included in the transaction price until the customer s subsequent sales or usage occurs regardless of whether the entity has predictive experience with similar arrangements. This is similar to current practice under IFRS and US GAAP as royalty revenue is generally recognised as the underlying sales are made. The exception is limited to licences of IP and does not apply to other arrangements. Despite a number of examples in the implementation guidance, the terms intellectual property and royalty are not defined under IFRS or US GAAP. As such, judgement will be required to determine whether an arrangement qualifies for the exception. Certain fixed payments might be in-substance variable sales- or usage-based royalties. For example, an arrangement might require a licensee to make a fixed payment that is subject to claw back if the licensee does not meet certain sales or usage targets. There is no explicit guidance for these types of fixed payments and therefore the accounting is dependent on an analysis of all of the facts and circumstances. These materials were downloaded from Inform ( under licence.page 72 / 307

73 Another complexity for the pharmaceutical and life sciences industry relates to evaluating how the exception applies to a contract with multiple performance obligations. For example, a biotechnology entity licences IP and agrees to perform R&D services for a pharmaceutical entity in exchange for consideration that includes a sales-based royalty. The biotechnology entity concludes that the licence and the R&D services should be combined and accounted for as a single performance obligation. Since the licence is not a separate performance obligation, the entity might conclude that it no longer qualifies for the exception for sales-based royalties. Evaluating whether a licence to IP is subject to the exception will be challenging and depend on an analysis of all the facts. The boundaries for determining when the sales- and usage-based exception applies might be an area of the new standard that is subject to further clarification. Distinguishing between a licence of IP and a sale of IP will also be important under the new standard. If an entity sells, rather than licenses the IP, then the exception for excluding salesand usage-based royalties from the transaction price is not applicable. Accordingly, for sales of IP, a minimum amount of royalty revenue will be initially recognised if it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of cumulative revenue will not occur. The initial estimate of royalty revenue is updated over time as the amount that is not at risk of a significant revenue reversal increases. Rebates, price protection and other discounts and incentives New standard Current US GAAP Current IFRS Rebates, price protection, concessions, and other discounts and incentives are types of variable consideration. Therefore, the The seller's price must be fixed or determinable for revenue to be recognised. Rebates, price protection clauses, and other discounts consideration will be estimated and incentives must be and included in the transaction analysed to conclude whether price based on either the expected value (probabilityweighted estimate) or most all of the revenue from the current transaction is fixed or determinable. likely amount approach if it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of cumulative revenue will not occur in the future. The transaction price should include any minimum amount of variable consideration not subject to significant reversal, even if the entire amount cannot be included in the transaction price due to the restraint. Rebates or refunds are recognised on a systematic and rational basis. Measurement of the total rebate or refund obligation is based on the estimated number of purchases that the customer will ultimately make under the arrangement. If the rebate or incentive payment cannot be reasonably estimated, a liability is recognised for the maximum potential refund or rebate. Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount an asset could be exchanged for, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Trade discounts, volume rebates, and other incentives (such as cash settlement discounts or government clawbacks) are taken into account in measuring the fair value of the consideration to be received. Revenue related to variable consideration is recognised when it is probable that the economic benefits will flow to the entity and the amount is reliably measurable, assuming all other revenue recognition criteria are met. Impact: Entities in the pharmaceutical and life sciences industry likely already consider the impact of rebates, price protection, and other concessions on revenue recognition. Entities might see some changes to their accounting and processes related to rebates or concessions as estimates are required upfront and revenue could be affected earlier (that is, reduced revenue in These materials were downloaded from Inform ( under licence.page 73 / 307

74 an earlier period due to an expectation that a concession will be granted). Other changes include those situations where entities did not recognise revenue because the price was not fixed or determinable. Under the new revenue standard, these entities might recognise revenue earlier if there is a minimum amount of variable consideration that is not subject to significant reversal in the future. Example 1 Estimating rebates to a customer Facts: A medical device entity enters into an arrangement to sell a product to a customer. At the end of each year, the customer is entitled to a rebate on its annual purchases. The medical device entity has determined based on its experience with similar contracts that it is probable that including an estimate of variable consideration will not result in a significant cumulative revenue reversal in the future. The estimated amount of the rebate is determined based on the number of units purchased during the year as follows: Units Purchased Per Unit Rebate Expected Probability 0 100,000 10% 80% 100, ,000 15% 15% 500, % 5% How should the medical device entity account for the potential rebate to the customer? Discussion: The medical device entity should estimate the amount of the rebate using an expected value (probability-weighted estimate) or most likely outcome approach, whichever is more predictive. A probability-weighted estimate results in a rebate of approximately 11% ((10% x 80%) + (15% x 15%) + (20% x 5%)). The most-likely outcome approach results in an estimated rebate of 10%. If the medical device entity is unsure whether the estimated amount will result in a significant reversal of revenue, the entity should only include in the transaction price an amount that is highly probable (IFRS) or probable (US GAAP) of not resulting in a significant reversal of revenue (that is, a minimum amount). Example 2 Discounts provided to group purchasing organisations Facts: A medical device entity sells disposable medical products to hospitals through a network of distributors at list price. The medical device entity has agreements in place with various group purchasing organisations (GPOs) to give a discount of 20% to specific hospitals affiliated with these GPOs. When a GPO-affiliated hospital purchases the disposable medical products from a distributor, it purchases them at the discounted amount. The distributor then requests reimbursement by the medical device entity of the discounted amount. The medical device entity has some historical data related to the mix of sales to GPOs and non-gpos; however, the range varies significantly from period to period. How should the medical device entity recognise revenue for this arrangement? Discussion: The medical device entity should recognise revenue at the time of delivery, which is when the distributor obtains control and can direct the use of the medical products. The medical device entity will estimate variable consideration, including the estimated discount to be paid on sales to GPO-affiliated hospitals. The amount of revenue recognised will be the amount that is highly probable (IFRS) or probable (US GAAP) of not resulting in a significant reversal of cumulative revenue in the future. Although the medical device entity s history varies significantly, that history may indicate there is a minimum amount of revenue that can be recognised upon shipment of the product. Sales to distributors and consignment stock These materials were downloaded from Inform ( under licence.page 74 / 307

75 Some pharmaceutical and medical technology entities recognise revenue using a sell-through approach. Under the sell-through approach, revenue is not recognised until the product is sold to the end customer, either because inventory is on consignment at distributors, hospitals, or others, or because the final selling price is not determinable until the product is sold to the end customer. Under the new standard, revenue is recognised upon the transfer of control to the customer. Entities that previously accounted for arrangements using a sell-through approach will need to consider at what point control has passed to the customer based on the indicators provided in the standard, which could impact the timing of revenue recognition. New standard Current US GAAP Current IFRS Revenue is recognised when or as performance obligations are satisfied, which occurs when control of a good or service transfers to the customer. Control refers to the ability to direct the use of and obtain substantially all of the remaining benefits (that is, potential cash flows) from the asset. Control also includes the ability to prevent others from directing the use of, or obtaining benefits from, the asset. The benefits from an asset include, but are not limited to: Revenue is recognised once the risks and rewards of ownership have transferred to the customer. Revenue is recognised once the risks and rewards of ownership have transferred to the customer. Using the asset to produce goods, provide services, enhance the value of others assets, settle liabilities, or reduce expenses. Physical possession. Ability to pledge the asset to secure a loan, sell the asset, or exchange the asset. Impact: These materials were downloaded from Inform ( under licence.page 75 / 307

76 The new standard requires an entity that has entered into a consignment stock arrangement with its customer to assess when control transfers to that customer. In the pharmaceutical and life sciences industry, the customer could be a distributor, hospital, or another entity. If the customer has control of the product, including the right (but not the obligation) to return the product to the seller at its discretion and the customer does not have a significant economic incentive to exercise the right feature, control transfers when the product is delivered to the customer. The entity would evaluate the return right as variable consideration. This might result in earlier revenue recognition than under current standards, which focus on the transfer of risks and rewards. Entities in the pharmaceutical and life sciences industry might account for product sales to a distributor utilising the sell-through model under current guidance if a reliable estimate of product returns cannot be made. Under the new standard, revenue is recognised when control of the product transfers to the customer. This could result in an entity that currently utilises a sellthrough model recognising revenue upon shipment to the distributor under the new standard. The amount of revenue recognised will be the amount that is highly probable (IFRS) or probable (US GAAP) of not resulting in a significant reversal of cumulative revenue in the future. Collaborations and licensing arrangements Pharmaceutical and biotechnology entities frequently enter into strategic collaborations and licensing arrangements. In determining how to account for such collaborations, the following key issues should be considered: Identifying whether the agreement falls within the scope of the new standard. Identifying the separate performance obligations and determining how to account for them. The standard requires entities to assess whether the counterparty to the arrangement is (1) a customer or (2) a collaborator or partner sharing in the risks and benefits of the arrangement. If such arrangements are outside the scope of the revenue standard, the related income might not meet the definition of revenue, but instead be recorded as a reduction of R&D expense or as other income. The following example illustrates the principles of the five-step approach for an arrangement with multiple performance obligations that is in the scope of the standard. Example 3 A collaboration arrangement with multiple performance obligations Facts: A biotech entity ( Biotech ) enters into a collaboration arrangement with a pharmaceutical entity ( Pharma ). Biotech grants an IP licence ( Licence A ) to Pharma and will perform R&D on the IP. Biotech receives an upfront payment of C40 million, per-hour payments for R&D services performed, and a milestone payment of C150 million upon regulatory approval. How should Biotech account for the arrangement? Discussion: Biotech determines the arrangement is in the scope of the new revenue standard as Biotech and Pharma have a vendor-customer relationship. Biotech is providing a licence and R&D services to Pharma and those goods or services are the output of Biotech s ordinary activities. The licence provides Pharma with the right to use Biotech s IP and Biotech performs other activities related to the licensed IP that might be separate performance obligations. Biotech determines there are two separate performance obligations in the arrangement: (1) transfer of Licence A and (2) performance of R&D services. This is because the licence could be sold separately and could be used by Pharma with its own resources as Pharma could choose to perform the research itself. Biotech estimates the payments for R&D services will be C12 million based on its expected effort taking into consideration past experience with similar arrangements. Thus, at contract These materials were downloaded from Inform ( under licence.page 76 / 307

77 inception, Biotech estimates a total transaction price of C52 million, which includes the upfront payment (C40 million) and the payments for R&D services (C12 million). Biotech estimates the consideration for the contingent milestone (C150 million) to be zero using the most likely amount approach at inception. Given that regulatory approval is highly uncertain and susceptible to external factors, Biotech cannot estimate an amount that is highly probable (IFRS) or probable (US GAAP) of not resulting in a significant reversal in the future. Biotech determines that the estimated transaction price at inception (C52 million) should be allocated to both performance obligations based on the relative stand-alone selling prices. Biotech determines a stand-alone selling price of C45 million for Licence A and C15 million for R&D services based on its estimate of the amount of hours necessary to perform R&D services plus a profit margin of 25%. The transaction price at inception is allocated 75% to Licence A and 25% to R&D as follows (in millions): Performance obligation Standalone price Relative % Upfront Payments payment for research Total 1. Licence A Research services Transfer of the licence Biotech transfers Licence A at the inception of the contract. The licence provides Pharma with the right to use Biotech s IP. Upon transfer of control of the licence to Pharma, Biotech recognises C39 million of revenue. R&D services Biotech recognises C13 million of revenue allocated to R&D services over the estimated service period based on a pattern that reflects the transfer of the services. The revenue recognised should reflect the level of service each period. In this case, Biotech uses an output model that considers estimates of the percentage of total R&D services that are completed each period compared to the total estimated services. The transaction price should be re-assessed at each reporting date. Biotech will include C150 million from the milestone payment in the total estimated transaction price at the point in time it determines it is highly probable (IFRS) or probable (US GAAP) such amount is not subject to significant revenue reversal in the future. At that time, Biotech should determine if it should allocate the milestone payment entirely to a specific performance obligation (that is, Licence A or the R&D services) or to both performance obligations. The new revenue standard provides guidance to help entities with this judgement. The new standard indicates that a contingent amount should be allocated entirely to a specific performance obligation if: (1) the contingent amount relates specifically to an entity s efforts to transfer a good or service; and (2) allocating the contingent amount entirely to the specific performance obligation is consistent with the overall allocation principle when considering all of the performance obligations and payment terms in the contract. In this example, Biotech makes a judgement that the milestone payment applies to both performance obligations (the licence and the R&D services). Therefore, Biotech will allocate the milestone payment to both performance obligations based on their relative stand-alone selling prices determined at the inception of the arrangement. The determination that the milestone payment does not only relate to efforts to transfer Licence A is judgemental and will depend on These materials were downloaded from Inform ( under licence.page 77 / 307

78 the specific facts and circumstances of each arrangement. Other considerations Time value of money The transaction price should be adjusted for the effect of the time value of money when the contract contains a significant financing component. A practical expedient allows entities to disregard the time value of money if the period between transfer of the goods or services and payment is less than one year, even if the contract itself is for more than one year. The following factors should be considered when evaluating if an arrangement includes a significant financing component: Whether the amount of consideration would substantially differ if the customer paid cash when the goods or services were transferred. The expected length of time between the transfer of the promised goods or services to the customer and the customer s payment. The prevailing interest rates in the relevant market. In addition, a contract with a customer would not have a significant financing component if any of the following factors exist: The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer. A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or non-occurrence of a future event that is not substantially within the control of the customer. The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract. It might be challenging to determine whether a significant financing component exists in a contract, particularly in long-term arrangements with multiple performance obligations where goods or services are delivered and cash payments are received throughout the arrangement. Management will need to assess the timing of delivery of goods and services in relation to cash payments to determine if there is a difference in excess of one year that could indicate that a significant financing component exists. Under the new revenue standard, an entity would adjust the transaction price for the effect of the time value of money if the timing of payments agreed to by the parties provides the customer or entity with a significant benefit of financing the transfer of goods or services to the customer. The discount rate used for this purpose should equal the rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract. Collectability Collectability refers to a customer s credit risk. It is the risk that an entity will be unable to collect from the customer the amount of consideration that the entity is entitled to under the contract. The new standard contains a collectability threshold that must be met prior to applying the revenue model. An entity needs to conclude it is probable under both IFRS and US GAAP, at the inception of the contract, that the entity will collect the consideration to which it will ultimately be entitled (that is, the transaction price) in order for a contract to exist. The assessment of These materials were downloaded from Inform ( under licence.page 78 / 307

79 collectability is based on both the customer s ability and intent to pay as amounts become due. An entity will only consider credit risk and no other uncertainties, such as those related to performance or measurement, as these are accounted for separately as part of determining the timing and measurement of revenue. The collectability threshold is not expected to significantly change current practice. An entity will assess whether collection of the transaction price is probable under both IFRS and US GAAP, and, if it is, the entity will recognise revenue as the performance obligation(s) are satisfied, similar to today s practice. If, at contract inception, an entity concludes that collectability of the transaction price is not probable, then a contract does not yet exist. Initial and subsequent impairment of customer receivables, to the extent material, will be presented separately below gross margin as an expense. This expense will be separately presented on the face of the income statement if it is material. Example 4 The impact of price concessions on the transaction price Facts: A pharmaceutical entity sells prescription drugs to a government entity in a country in Southern Europe for C5 million. The pharmaceutical entity has historically experienced long delays in payment for sales to this entity due to slow economic growth and high debt levels in the country. The pharmaceutical entity has sold prescription drugs to this entity for the last five years and continues to sell prescription drugs at its normal market price. In the past, the pharmaceutical entity has ultimately been paid, but only after agreeing to significant price concessions. How should the pharmaceutical entity account for the C5 million sale to the government entity? Discussion: The pharmaceutical entity will need to evaluate its contract with the government entity, at the inception of the arrangement, to determine if it is probable that it will collect the amounts to which it is entitled in exchange for the prescription drugs. The new revenue standard indicates that for purposes of determining the transaction price, the entity should consider the variable consideration guidance, including the possibility of price concessions. Based on its historical experience, the pharmaceutical entity expects to ultimately provide a price concession of C3 million to collect its receivable. As a result, the transaction price is C2 million. The pharmaceutical entity would then evaluate whether it is probable it will collect the adjusted transaction price. Assuming the collectability hurdle is met, the transaction price will be recognised as the pharmaceutical entity satisfies its performance obligation of delivering the drug. The new revenue standard includes a similar example (Example 2) illustrating a situation where there is an implicit price concession and the transaction price is not the stated price. However, Example 2 does not address the time value of money. Specifically, before concluding that the transaction price is C2 million, the pharmaceutical entity will need to consider if there is a significant financing element in the arrangement due to the anticipated length of time between the sale of the prescription drug and expected payment from the governmental entity. Bill-and-hold arrangements Pharmaceutical, biotechnology, and medical technology entities may have bill-and-hold arrangements with their customers where an entity bills a customer for a product, but does not ship the product until a later date. Entities can currently recognise revenue when product is billed (rather than on delivery) under arrangements that meet certain criteria. The new revenue standard focuses on when control of the goods transfers to the customer to determine when revenue is recognised. Depending on the terms of the contract, control may be transferred either when the product is delivered to the customer site or when the product is shipped. However, for some contracts, a customer may obtain control of a product even though These materials were downloaded from Inform ( under licence.page 79 / 307

80 that product remains in an entity s physical possession. In that case, the customer has the ability to direct the use of, and obtain the remaining benefits from the product, even though it has decided not to take physical possession of the product. For a customer to have obtained control of a product in a bill-and-hold arrangement, the following criteria must be met: (1) the reason for the arrangement is substantive, (2) the product has been identified separately as belonging to the customer, (3) the product is ready for delivery in accordance with the terms of the arrangement, and (4) the entity does not have the ability to use the product or sell the product to another customer. Entities will need to consider the facts and circumstances of their arrangements to determine whether control of the product has transferred to the customer prior to delivery. The requirement to have a fixed delivery schedule often precludes revenue recognition for bill-and-hold arrangements under current US GAAP; however, this requirement is not included in the new revenue standard. Government vaccine stockpile programs Government vaccine stockpile programs often require an entity to have a certain amount of vaccine inventory on hand for use by a government at a later date. The bill-and-hold criteria in US GAAP for revenue recognition are typically not met even though these arrangements were at the request of the government. Such arrangements generally do not include a fixed schedule for delivery and the vaccine stockpile inventory may not be segregated from the entity s inventory. In many cases, entities rotate the vaccine stockpile to ensure it remains viable (does not expire). The SEC provides an exception for entities that participate in US government vaccine stockpile programs, which permits them to recognise revenue at the time inventory is added to the stockpile, provided all other revenue recognition criteria have been met. For entities following US GAAP, the exception applies only to US government stockpiles and only to certain vaccines. For entities following IFRS, depending on the substance of the arrangement, revenue might be recognised when the inventory is added to the stockpile if the bill-and-hold requirements under IFRS are met. Entities that participate in government vaccine stockpile programs will need to assess whether control of the product has transferred to the government prior to delivery under the new standard. The standard does not require a fixed delivery schedule to recognise revenue, but the requirement for transfer of control may not be met if the stockpile inventory is not separately identified as belonging to the customer and is subject to rotation. It is not clear whether the SEC will carry forward its exception once the new revenue standard is effective. Entities will also need to consider their performance obligations under the arrangement if control is deemed to transfer prior to delivery. For example, entities need to assess if the storage of stockpile product, the maintenance and rotation of stockpile product and delivery of product are separate performance obligations. Right of return Pharmaceutical, biotechnology, and certain medical technology entities may sell products with a right of return. The right of return often permits customers to return product within a few months prior to and following product expiration. Return rights may also take on various other forms, such as trade-in agreements. These rights generally result from the buyer's desire to mitigate the risk related to the products purchased and the seller's desire to promote goodwill with its customers. The sale of goods with a right of return will be accounted for similar to current guidance, which results in revenue recognition for only those products when the entity concludes it is highly probable (IFRS) or probable (US GAAP) that there is not a risk of significant revenue reversal in future periods. Pharmaceutical entities usually destroy returned inventory, but certain medical technology entities can resell returned product. The impact of product returns on earnings under the new standard will be largely unchanged from current IFRS and US GAAP. However, the balance sheet will be grossed up to include the refund obligation and the asset for the right to the returned goods. The asset is assessed for impairment if indicators of impairment exist. These materials were downloaded from Inform ( under licence.page 80 / 307

81 Product warranties Many products are sold with implicit or explicit warranties indicating that the product sold to the customer meets an entity's quality standards and that the product is usable and not defective. Some entities also offer extended warranties, which provide for coverage beyond the standard warranty period. The new standard draws a distinction between product warranties that the customer has the option to purchase separately (for example, warranties that are negotiated or priced separately) and product warranties that the customer does not have the option to purchase separately. Judgement will need to be exercised when assessing a warranty not sold separately to determine if there is a service component to be accounted for as a separate performance obligation. New standard Current US GAAP Current IFRS An entity should account for a warranty that the customer has the option to purchase separately as a separate performance obligation. A warranty that the customer does not have the option to purchase separately should be accounted for in accordance with existing guidance on product warranties so long as the warranty only provides assurance that the product complies with agreed-upon specifications. A warranty, or a part of the warranty, which is not sold separately but provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications, creates a performance obligation for the promised service. An entity that cannot reasonably separate the service component from a standard warranty should account for both together as a separate performance obligation. Warranties that protect against latent defects are accounted for as a loss contingency and do not generally constitute a deliverable. An entity records a liability for a warranty contingency and related expense when it is probable that a loss covered by the warranty has been incurred and the amount of the loss can be reasonably estimated. In determining whether the loss can be reasonably estimated, an entity normally takes into account its own experience or other available information. Warranties that provide protection for defects that arise after the product is transferred are considered separate deliverables for which revenue is deferred and recognised over the expected life of the contract. Products are often sold with a standard warranty, which protects the customer in the event that an item sold proves to have been defective at the time of sale (usually based on evidence coming to light within a standard period). This is not usually considered separable from the sale of goods. When the warranty is not a separate element, and represents an insignificant part of the sale transaction, the full consideration received is recognised as revenue on the sale and a provision is recognised for the expected future cost to be incurred relating to the warranty. If an entity sells a product with an extended warranty, it is treated as a multiple-element arrangement and the revenue from the sale of the extended warranty is deferred and recognised over the warranty period. A provision is recognised for replacement only as defects arise through the warranty period. This differs from a standard warranty where provision is made at the time the goods are sold. Impact: Similar to existing IFRS and US GAAP, extended warranties give rise to a separate performance These materials were downloaded from Inform ( under licence.page 81 / 307

82 obligation under the new revenue standard and, therefore, revenue should be recognised over the warranty period. Warranties that are separately priced under US GAAP may be impacted as the arrangement consideration will be allocated on a relative stand-alone selling price basis rather than at the contractual price. The amount of deferred revenue for extended warranties might differ under the new revenue standard compared to current guidance as a result. Product warranties that are not sold separately and provide for defects that exist when a product is shipped will result in a cost accrual similar to current guidance. Disclosures The revenue standard includes a number of extensive disclosure requirements intended to enable users of financial statements to understand the amount, timing, and judgements related to revenue recognition and corresponding cash flows arising from contracts with customers. We highlight below some of the more significant disclosure requirements, but the list is not allinclusive. The disclosures include qualitative and quantitative information about: contracts with customers; the significant judgements, and changes in judgements, made in applying the guidance to those contracts; and assets recognised from the costs to obtain or fulfil contracts with customers. The disclosure requirements are more detailed than currently required under IFRS or US GAAP and focus significantly on the judgements made by management. For example, they include specific disclosures of the estimates used and judgements made in determining the amount and timing of revenue recognition. Pharmaceutical and life sciences entities could face challenges in estimating stand-alone selling price for certain deliverables (such as licences), as well as determining the transaction price for variable consideration, and the judgements and methods used to make the estimates will have to be disclosed. The revenue standard also requires an entity to disclose the amount of its remaining performance obligations and the expected timing of the satisfaction of those performance obligations for contracts with durations of greater than one year, and both quantitative and qualitative explanations of when amounts will be recognised as revenue. This requirement could have a significant impact on the pharmaceutical and life sciences industry, where long-term contracts are a significant portion of an entity s business. About PwC s Pharmaceutical & Life Science practice PwC is dedicated to delivering effective solutions to the complex business challenges facing pharmaceutical and life sciences companies. As a leader serving the industry with more than 3,000 industry-dedicated partners and staff worldwide, we provide audit and assurance, tax and advisory services to an array of both top tier and middle market companies. We have specialised advisory capabilities in research and development, supply chain management, and sales and marketing, as well as in key operational areas, including finance, regulatory compliance, corporate development, information systems and human resources management. Our commitment to the industry is broad-based and our clients include proprietary and generic drug manufacturers, wholesalers and distributors, specialty drug companies, medical device and diagnostics suppliers, biotechnology companies, pharmacy benefit managers, contract research organisations, and industry associations. 1 The revenue standard includes an example specific to the pharmaceutical and life sciences industry to assist entities in evaluating whether a license is distinct. These materials were downloaded from Inform ( under licence.page 82 / 307

83 Communications industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for entities in the communications industry as they transition to the new standard. Overview The communications industry comprises several subsectors, including wireless, fixed line, and cable/satellite television (TV). These entities generate revenue through many different service offerings that include access to, and usage of, network and facilities for the provision of voice, data, internet, and television services. These services generate revenues through subscription fees or usage charges. Some communications entities also sell or lease equipment such as handsets, modems, dongles (a wireless broadband service connector), customer premises equipment (CPE), and a variety of accessories. Newer offerings are also emerging such as instalment sales of wireless devices; multi-line plans, where customers attach more than one device to a service; and bundled plans, with core video service, including voice and internet services, combined with newer offerings like home security services. Cloud services and machine-to-machine services are also a growth area. The revenue standard will impact each of these businesses with certain changes having the potential for the greatest impact: Additional revenue may need to be allocated to discounted or free products provided at the beginning of a service period due to the elimination of the contingent revenue cap, and changes to and restrictions in the use of the residual method currently applied by some communications entities. The revenue standard could affect the accounting treatment of activation fees, customer acquisition costs, and certain contract fulfilment costs. The guidance may be applied to a portfolio of contracts or performance obligations in some circumstances, although this approach may create additional implementation challenges and complexities. Communications entities are continually evaluating their business models and providing new device and service plans to customers. Assessing the accounting impact of these new services can be challenging. During the transition to the revenue standard, management will need to consider the impact these new offerings have under both the old and new guidance, adding complexity to their growing list of challenges. Identifying performance obligations A performance obligation is a promise to transfer a distinct good or service to a customer. These materials were downloaded from Inform ( under licence.page 83 / 307

84 Identifying the separate performance obligations within a contract affects both when and how much revenue is recognised. Entities will need to determine whether performance obligations within customer contracts should be accounted for separately or bundled together. A performance obligation might be explicit in a contract, or implicit, arising from customary business practices. Applying the separation principle might be challenging where there are multiple offerings in bundled packages. Communications entities regularly bundle the sale of telecom services and equipment (for example, handsets, modems, accessories, etc.) and might also include a charge for activation or set up. Wireless entities give free or significantly discounted handsets to customers in some countries as an incentive to enter long-term telecom service contracts (for example, one- and two-year contracts). Equipment (including handsets) transferred to customers is a separate performance obligation in most cases if the entity separately sells equipment or the customer can benefit from the handset together with other resources (for example, the handset could operate on another communications entity s network). This is true regardless of whether the equipment is given at no cost or at a significantly discounted price. Other obligations such as promises of future discounted services or other material rights will also need to be evaluated to determine if they qualify as separate performance obligations. Final standard Current US GAAP Current IFRS Performance obligations The revenue standard requires entities to identify all promised goods or services in a contract and determine whether to account for each promised good or service as a separate performance obligation. A performance obligation is a promise in a contract to transfer a distinct good or service to a customer. A good or service is distinct and is separated from other obligations in the contract if: the customer can benefit from the good or service separately or together with other resources; and the good or service is separately identifiable from other The following criteria are considered to determine whether elements included in a multiple-element arrangement are accounted for separately: The delivered item has value to the customer on a stand-alone basis. If a general return right exists for the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. The revenue recognition criteria are usually applied separately to each transaction. It might be necessary to separate a transaction into identifiable components to reflect the substance of the transaction in certain circumstances. Separation is appropriate when identifiable components have stand-alone value and their fair value can be measured reliably. Two or more transactions might need to be grouped together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. These materials were downloaded from Inform ( under licence.page 84 / 307

85 goods or services in the contract. A series of distinct goods or services that are substantially the same are accounted for as a single performance obligation if: each would be a performance obligation satisfied over time; and the same method would be used to measure the entity s progress toward satisfaction. Examples of this could include network access or call centre services provided continuously over a period of time. Options to acquire additional goods or services An entity might grant a customer the option to acquire additional goods or services free of charge or at a discount. These options might include customer award credits or other sales incentives and discounts. An option gives rise to a separate performance obligation if it provides a material right that the customer would not receive without entering into the contract. The entity should recognise revenue allocated to the option when the option expires or when the additional goods or services are transferred to the customer. An option to acquire an additional good or service at a When an option is determined to be substantive, an entity evaluates whether that option has been offered at a significant incremental discount. If the discount in an arrangement is significant, a presumption is created that an additional deliverable is being offered in the arrangement requiring a portion of the arrangement consideration to be deferred at inception. These materials were downloaded from Inform ( under licence.page 85 / 307 The recognition criteria are usually applied separately to each transaction (that is, the original purchase and the separate purchase associated with the option). However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components as a single transaction in order to reflect the substance of the transaction. If an entity grants to its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, the entity accounts for that option as a separate component of the

86 price that is within the range of prices typically charged for those goods or services does not provide a material right, even if the option can be exercised only because of entering into the previous contract. Non-refundable upfront fees Some entities charge a customer a non-refundable upfront fee at or near contract inception. Entities will need to determine whether the nonrefundable upfront fee relates to the transfer of a good or service to a customer. The standard states that activation services are an example of non-refundable upfront fees that do not result in the transfer of a good or service to the customer. The payment for the activation service is an advance payment for future communications services. Unless an upfront fee is in exchange for products delivered or services performed that represent the culmination of an earnings process, an upfront fee should be deferred and recognised systematically over periods that the fees are earned. In cases in which an upfront fee is not related to specific products or services, the fee should be excluded from the consideration that is allocated to the deliverables and recognised over the longer of the initial contractual term of the arrangement or the estimated period the customer is expected to benefit from the payment of the upfront fee (that is, the customer benefit period). arrangement and therefore allocates consideration between the initial good or service provided and the option. Recognition of revenue from an upfront fee depends on the nature of the services provided. An entity must determine whether an upfront fee related to installation or activation is a separate component of the transaction. Generally, activation fees for communications services are not a separate component of the transaction. The activation fees are generally recognised over the period the communications services are provided to the customer. When all or a portion of an upfront fee is related to a specific deliverable(s) within the arrangement, the upfront fee, or a portion thereof, should be included within the consideration that is allocated to the deliverables using the relative selling price method. Potential impact - both IFRS and US GAAP Entities will need financial processes that identify the different performance obligations in each contract and pinpoint when and how those obligations are fulfilled. Traditionally, wireless communications entities have identified the device and service as separate units of accounting under existing guidance, but they will need to consider whether additional performance obligations exist under the new model. This assessment will need to extend to all obligations under a contract, even items that are not regularly sold by the entity, or that have previously been viewed as marketing expenses (for example, provision of free products not related to the provision of communications services). These materials were downloaded from Inform ( under licence.page 86 / 307

87 Communications entities will have to carefully consider outsourcing and network IT contracts, various types of activation/connection services, and other upfront services (for example, connecting customers to their network or laying physical line to the customers premises) to determine if these services meet the definition of a separate performance obligation and if a good or service is transferred to the customer. The timing of revenue recognition for communications entities that currently do not account for equipment (for example, handsets) separately from the telecom services will be significantly affected if the components of their bundled offerings are separate performance obligations under the revenue standard. Many entities charge activation fees at the inception of a contract. The activation services are typically not a separate performance obligation. Activation fees are advance payment for future goods or services and, therefore, would be recognised as revenue when those future goods or services are provided. The recognition period could extend beyond the initial contractual term if the customer has the option to renew and that option provides the customer with a material right (for example, an option to renew without requiring the customer to pay an additional activation fee). Entities should carefully consider the impact of options on all contracts, including month-tomonth service arrangements. This may result in a different pattern of revenue recognition from today s accounting models under which activation fees are often recognised over the contract period. Communications entities increasingly sell multi-line plans and will need to determine whether the option to add additional lines is a material right that is a separate performance obligation. Example 1 Identifying performance obligations Question: A communications entity enters into a contract with a customer to provide wireless telecom services (voice, data, etc.) for C50 per month and a handset for C100. It also charges an activation fee of C30. The communications entity sells handsets separately (for example, when a customer s handset is lost, stolen, or damaged). How many separate performance obligations are in this contract? Discussion: Two separate performance obligations exist in this arrangement: wireless telecom services and the handset. The handset is a separate performance obligation because the entity sells the handset separately. The handset is a separate performance obligation even if the entity does not sell the handset separately, if the customer could use the handset to receive telecom services from another entity (that is, there are no technological or legal barriers that prevent customers from using the equipment on another entity s network). Activation/connection fees are not separate performance obligations, but are considered upfront payments for the handset and future telecom services. Example 2 Options that do not provide a material right Question: A communications entity enters into a two-year contract with a customer to provide wireless telecom services (voice, data, etc.) for C50 per month. The contract requires the communications entity to provide the customer with 800 voice minutes and 100 text messages per month. The contract specifies the customer may purchase additional voice services for C0.10 per minute and text services for C0.20 per message during the contract. These prices are typically charged for those services regardless of the type of contract and therefore reflect the stand-alone selling price of those services. Is the customer s option to purchase additional voice minutes and text messages a separate performance obligation? Discussion: The option provided in the contract is not a performance obligation because it does not provide a material right to the customer. The customer pays the same price, or price within a range, for voice minutes and text messages as other customers. The entity will recognise revenue for the additional voice minutes and text messages if and when the customer receives These materials were downloaded from Inform ( under licence.page 87 / 307

88 those additional services. Example 3 Installation services Question: A communications entity enters into a contract to provide telecom services (voice, data, etc.) on a monthly basis, with no contract end date. An upfront, non-refundable installation fee of C50 is charged to recover the cost of laying physical line to the customer s premises. This line can be used by other communications entities if the customer later changes service providers. Is the installation service a separate performance obligation? Discussion: The entity will need to determine whether laying the physical line is a distinct good or service. In this example, other communications entities can provide services on the same physical line, so the line is separately identifiable and can be used by the customer without the entity subsequently providing telecom services. Laying the physical line is therefore a distinct performance obligation. Example 4 Cable entity, activation services Question: A cable entity enters into a contract to provide services (voice, television, internet, etc.) on a monthly basis, with an initial contract period of 12 months. An upfront, non-refundable fee of C50 is charged to recover the cost of sending a technician to activate the service for the customer s premises. Is the activation service a separate performance obligation? Discussion: The entity will need to determine whether the activation is a distinct service. In this example, the activation services are not distinct from the provision of the voice and data services because the customer cannot benefit separately from the activation service. The activation fee should be deferred and recognised over at least the contract period. Entities will need to determine if the activation fee relates to the provision of services that extend beyond the initial contract period, and should be recognised over that longer period. This could be the case if the customer has a material right to extend the contract without paying an additional activation fee. Determining the transaction price The transaction price is the amount of consideration an entity is entitled to receive in exchange for transferring goods or services to customers. Determining the transaction price is straightforward when the contract price is fixed; it becomes more complex when it is not fixed. Discounts, rebates, refunds, credits, incentives, performance bonuses, and price concessions could cause the amount of consideration to be variable. The guidance on variable consideration might require communications entities to recognise revenue earlier than current practice. Final standard Current US GAAP Current IFRS Variable consideration The transaction price might include an element of consideration that is variable or contingent upon the outcome of future events, such as discounts, rebates, refunds, credits, incentives, etc. An entity should use the The seller s price must be fixed or determinable in order for revenue to be recognised. Revenue related to variable consideration generally is not recognised until the uncertainty is resolved. It is Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount for which an asset or liability could be exchanged or settled between knowledgeable, willing parties in an arm s length transaction. These materials were downloaded from Inform ( under licence.page 88 / 307

89 expected value or most likely outcome approach to estimate variable consideration, depending on which is the most predictive. An estimate of variable consideration is included in the transaction price to the extent it is highly probable (IFRS) or probable (US GAAP) that a significant reversal will not occur in future periods. Highly probable under IFRS means the same as probable under US GAAP. The estimate should be updated at each reporting period. If an entity receives consideration from a customer and expects to refund some or all of that consideration to the customer, the entity recognises a refund liability for an amount the entity expects to refund. Customers might not exercise all of their contractual rights related to a contract, such as mail-in rebates and other incentive offers. Entities will need to continually update their estimates to adjust for changes in expectations. The revenue standard explains several factors entities should consider in making this assessment to determine the amount of consideration to which an entity expects to be entitled. not appropriate to recognise revenue based on the probability of an uncertainty being achieved. Certain sales incentives entitle the customer to receive a cash refund (for example, a rebate) for some of the price charged for a product or service. The vendor recognises a liability for those sales incentives based on the estimated refunds or rebates that will be claimed by customers. A liability (or deferred revenue) is recognised for the maximum potential amount of the refund or rebate (that is, no reduction is made for expected breakage) if future refunds or rebates cannot be reasonably and reliably estimated. Trade discounts, volume rebates, and other incentives (such as cash settlement discounts) are taken into account in measuring the fair value of the consideration to be received. Revenue related to variable consideration is recognised when it is probable that the economic benefits will flow to the entity and the amount is reliably measurable, assuming all other revenue recognition criteria are met. A liability is recognised based on the expected levels of rebates and other incentives that will be claimed. The liability should reflect the maximum potential amount if no reliable estimate can be made. Potential impact - both IFRS and US GAAP Some entities will recognise revenue earlier under the revenue standard because variable consideration is included in the transaction price prior to the date on which all contingencies are resolved. For example, a network provider might offer other communications entities (customers) volume discounts on usage rates (voice and data access) to access its network as part of a minimum purchase commitment arrangement. The network provider charges penalties or the customers lose the volume discounts if the customers do not meet specified usage volumes. Communications entities that offer such discounts under minimum purchase commitment arrangements, and determine it is highly probable (IFRS) or probable (US GAAP) they will receive penalties or additional payments because customers fail to meet the specified These materials were downloaded from Inform ( under licence.page 89 / 307

90 usage volumes, could recognise revenue earlier than under current guidance. Entities will also have to estimate amounts related to incentives and consider the guidance for variable consideration to determine the amounts they expect to be entitled to, considering their experience with existing incentives, discounts, take-rates, and other external factors. The revenue standard requires entities to adjust the promised amount of consideration to reflect the time value of money if the contract has a significant financing component. Factors to consider when determining whether a contract has a significant financing component include, but are not limited to: (a) the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services, (b) whether the amount of consideration would differ substantially if the customer paid in cash promptly in accordance with typical credit terms in the industry and jurisdiction, and (c) the interest rate in the contract and prevailing interest rates in the relevant market. Communications entities should consider whether the transfer of a handset to a customer at the initiation of the contract and collecting monthly payment for the handset over the contract period provides the customer with a significant financing benefit, which would result in an adjustment to the transaction price to reflect the financing component. Example 5 Discount program, revenue is not constrained Question: A communications entity enters into contracts with its customers to provide telecom services (voice, data, etc.) for C50 per month and Equipment X for C200. The customers will receive a discount of C100 related to the purchase of Equipment X, if they submit a properly completed form and proof of purchase via mail (also known as a mail-in-rebate). The entity has predictive experience from providing similar discounts to a range of customers (that is, refund amounts for similar equipment with similar sales prices). The entity concludes there are no external economic factors that affect historical trends, and that historically approximately 75% of customers take advantage of the rebate. How should the entity account for this transaction? Discussion: The entity should estimate the transaction price based on the amounts it expects to be entitled to. The most recent history for similar discount programs (that is, refund amounts for similar equipment with similar sales prices) is used to estimate the amount to which the entity expects to be entitled. The refund liability for each transaction is estimated using the following probabilities representing the pattern of similar rebates. Amount Probability Probabilityweighted amount C % 25% C 0 75 C 75 The entity concludes it is highly probable (IFRS) or probable (US GAAP) that variable consideration of C25 will not be subject to significant reversal. The entity will record a refund liability of C75 and reduce the transaction price by C75. The entity will update the estimated liability at each reporting period, with any adjustments recorded to revenue. These materials were downloaded from Inform ( under licence.page 90 / 307

91 Example 6 Discount program, revenue is constrained Question: A communications entity is launching its service in a certain country for the first time and enters into contracts with its customers to provide telecom services (voice, data, etc.) for C50 per month and Equipment Y for C350. The customers receive a discount of C100 related to the purchase of the equipment if they submit a proper form and proof of purchase via mail. The entity does not have predictive experience providing similar discounts (that is, refund amounts for similar equipment with similar sales prices) in this country and concludes that there is no amount of the variable consideration (the potential discount) that is highly probable (IFRS) or probable (US GAAP) of not being subject to a significant reversal. How should the entity account for this transaction? Discussion: The entity will record a full refund liability of C100 and reduce the transaction price by C100 as there is no amount of the potential discount that is highly probable (IFRS) or probable (US GAAP) of not being subject to a significant reversal. The liability will be recognised as revenue as soon as management is able to conclude it is highly probable (IFRS) or probable (US GAAP) that there will be no reversal for some part of the consideration or the right to the discount expires. The entity will update the estimated liability at each reporting period, with any adjustments recorded to revenue. Example 7 Minimum purchase contract Question: A communications entity enters into a contract with another communications entity (customer) to provide access to its network over a one-year period. The contract offers a discounted usage rate of C0.05 per voice minute. The discounted rate is contingent upon the customer s minimum monthly purchase commitment of 25 million minutes of network voice usage. If the customer is unable to meet the volume commitments, the usage rate increases to C0.08 per voice minute, applied retroactively. How should the communications entity providing network access account for this transaction? Discussion: The entity should estimate the variable consideration to determine the transaction price. The entity determines, based on its facts and circumstance, including the customer s usage history, that there is an 85% probability the customer will meet the minimum monthly volume commitments for the contract period and a 15% probability the customer will not meet the minimum commitments. The entity determines to use the most likely outcome method as it is the best prediction of the amount it expects to receive. It also determines that there is no amount in excess of C0.05 per minute that is highly probable (IFRS) or probable (US GAAP) of not being reversed. Therefore, the entity will recognise revenue based on a transaction price of C0.05 per voice minute. Allocating the transaction price Communications entities, as previously discussed, often provide multiple products and services to their customers as part of a bundled offering. These arrangements usually consist of the sale of telecom services and the sale of equipment (wireless handset, modem, etc.). Some communications entities also charge customers an upfront activation fee. Under current guidance, communications entities reporting under US GAAP are required to apply a contingent revenue cap, while most communications entities reporting under IFRS use either a residual method or apply a contingent revenue cap. The contingent revenue cap limits the amount of consideration allocated to the delivered item (for example, a handset) to the amount that is not contingent on the delivery of additional items (for example, the telecom services). Final standard Current US GAAP Current IFRS The transaction price is allocated to separate Arrangement consideration is allocated to each unit of Revenue is measured at the fair value of the consideration These materials were downloaded from Inform ( under licence.page 91 / 307

92 performance obligations in a contract based on relative stand-alone selling prices. The stand-alone selling price is the price at which the entity would sell a good or service separately to the customer. The best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately. Entities will need to estimate the selling price if a stand-alone selling price is not observable. In doing so, the use of observable inputs is maximised. Possible estimation methods include: Expected cost plus reasonable margin. Assessment of market price for similar goods or services. Residual approach, in limited circumstances. A residual approach may be used to estimate the standalone selling price when the selling price of a good or service is highly variable or uncertain. A selling price is highly variable when an entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when an entity has not yet established a price for a good or service and the good or service has not previously been sold. accounting based on the relative selling price. Third-party evidence (TPE) of fair value is used to separate deliverables when vendorspecific objective evidence (VSOE) of fair value is not available. Best estimate of selling price is used if neither VSOE nor TPE exist. The term selling price indicates that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. The residual or reverse residual methods are not allowed. When performing the allocation using the relative selling price method, the amount of consideration allocated to a delivered item is limited to the consideration received that is not contingent upon the delivery of additional goods or services. This limitation is known as the contingent revenue cap. Communications entities typically account for the sale of the equipment and telecom services in a bundled offering as separate units of accounting, with telecom services collectively accounted for as a single unit of account, as they are generally delivered at the same time. The arrangement consideration that can be allocated to the equipment is generally limited to cash received because future cash receipts are contingent upon the entity providing telecom services. Therefore, when the handset is transferred, revenue is recognised at the amount that the customer paid for the handset at contract inception. The remaining contractual payments are recognised subsequently as the entity These materials were downloaded from Inform ( under licence.page 92 / 307 received or receivable. Fair value is the amount for which an asset or liability could be exchanged or settled, between knowledgeable, willing parties in an arm s length transaction. IFRS does not mandate how consideration is allocated and permits the use of the residual method, where the consideration for the undelivered element of the arrangement (normally service or tariff) is deferred until the service is provided, when this reflects the economics of the transaction. Any revenue allocated to the delivered items is recognised at the point of sale.

93 provides network services to the customer. Potential impact - both IFRS and US GAAP The revenue standard s allocation requirements will have significant implications to the telecom industry. It requires the transaction price be allocated to each separate performance obligation in proportion to the stand-alone selling price of the good or service. It therefore eliminates the contingent revenue cap. The revenue standard also substantially reduces the circumstances in which a residual approach can be applied. The residual approach is different from the residual method that is used today. Applying today s residual method results in the entire discount in an arrangement being allocated to the first item delivered under the contract. This will not be the case under the revenue standard. Judgement will be needed to determine the stand-alone selling price for each separate performance obligation in a customer contract (the telecom services and equipment). There is good visibility into the pricing of communications equipment and the associated telecom service in some markets. However, in many markets, communications entities charge customers little, if anything, for the equipment and only sell equipment bundled with the telecom services. If communications entities do not separately sell equipment, management may have to use various estimation methods, including, but not limited to a market assessment approach or a cost plus margin approach. Determining the stand-alone selling price of certain services may also present challenges. Historically, there was a reasonable level of consistency in the amounts charged for bundled services within operators and between operators. Today, there is increasing variability in the amounts charged for equivalent bundles of services. For example, the amount charged for services can vary depending on the number and mix of devices chosen by the customer, including SIM-only deals, where the monthly price for service is less when the customer does not take a subsidised device, or multi-line plans. The revenue standard will likely require entities to allocate more of the transaction price to the equipment than under the current guidance, and result in earlier recognition of revenue. Recognising more revenue than consideration received also results in the recognition of a contract asset, which will need to be monitored for impairment. Entities will face practical challenges in allocating the transaction price for a large volume of customer contracts with varying configurations of equipment and service plans. The revenue standard permits an entity to apply the guidance to a portfolio of contracts (or performance obligations) with similar characteristics if the entity reasonably expects that the effects on the entity s financial statements of doing so would not differ materially from the results of applying the guidance to individual contracts (or performance obligations). The boards acknowledged in their basis for conclusions that this approach may be particularly useful to entities in the telecommunications industry. The boards also noted that entities should be able to take a reasonable approach to identify portfolios for applying this guidance, as opposed to a quantitative evaluation. Entities should consider whether they need to modify existing systems or develop new systems to gather information on customer contracts and to perform the required allocations of the transaction price between separate performance obligations. Example 8 Allocating the transaction price Question: A wireless entity enters into sales arrangements with two different customers: Customer A and Customer B. Each customer purchases or receives the same handset and selects the same monthly service plan. The stand-alone selling price for the handset is C300 (it These materials were downloaded from Inform ( under licence.page 93 / 307

94 is purchased wholesale by the wireless entity for C290) and the stand-alone selling price of the telecom service plan is C40 per month. Customer A purchases the handset for C300 and enters into a cancellable contract to receive the telecom services (voice and data) for C40 per month. Customer B enters into a 24-month service contract for C40 per month and receives a discounted handset for C50. In summary: Customer A Customer B Stand-alone selling price of handset C 300 C Stand-alone selling price of services 40 (C40 x 24 months) Total C 340 C1,260 Cost of equipment C 290 C 290 Customer A transaction price C 340 (C300 handset + C40 for one month of service) Customer B transaction price C 1,010 (C960 services + C50 for handset) How should the transaction price be allocated to the performance obligations in the contracts with Customer A and B? Discussion: The entity needs to identify the separate performance obligations within customer contracts. The sales of telecom services and handsets are typically separate performance obligations given they are distinct goods and services. Revenue is recognised when a promised good or service is transferred to the customer and the customer obtains control of that good or service. Revenue is recognised for the sale of the handset at delivery, when the communications entity transfers control of the handset to the customer. Service revenue is recognised over the contract service period. For simplicity, the example assumes the potential financing impact of transferring the handset to the customer at the initiation of the contract and collecting the customer s monthly payment over the 24-month contract period is insignificant. The tables below compare the effect of applying the allocation guidance in the revenue standard with that of the current guidance. Current guidance existing US GAAP guidance (contingent revenue cap) Customer Day 1 Month 1 Month 2 Month 3 Customer A C300 (a) C40 (a) C40 C40 Customer B 50 (b) Total C350 C80 C80 C80 (a) Recognise revenue for the sale of the handset (C300) and service (C40) based on the relative stand-alone selling prices. (b) Recognise revenue for the amount of consideration received (C50) that is not contingent upon the delivery of additional items (telecom services). Current guidance existing IFRS guidance (residual method) These materials were downloaded from Inform ( under licence.page 94 / 307

95 Customer Day 1 Month 1 Month 2 Month 3 Customer A C300 (a) C40 (a) C40 C40 Customer B 50 (b) Total C350 C80 C80 C80 (a) Under the residual method, the amount of consideration allocated to the delivered item (C300) equals the total arrangement consideration (C340) less the aggregate fair value of the undelivered item(s) (C40). (b) Under the residual method, the amount of consideration allocated to the delivered item (C50) equals the total arrangement consideration (C1,010) less the aggregate fair value of the undelivered item(s) (C960). New guidance revenue recognised Customer Day 1 Month 1 Month 2 Month 3 Customer A C300 (a) C40 (a) C40 C40 Customer B 240 (b) 32 (c) 32 (c) 32 (c) Total C540 C72 C72 C72 (a) Handset: C300 = (C300 / C340) x C340; One month of service C40 = (C40 / C340) x C340. (b) Handset: C240 = (C300 / C1,260) x C1,010. (c) Monthly service revenue: C32 = (C960 / C1,260) x C1,010 = C770 / 24 months. In this example, the communications entity will recognise C190 more in equipment revenue compared to current IFRS and US GAAP. The communications entity will also recognise a net contract asset of C190 under the revenue standard (C540 less C350 cash received). This asset will have to be monitored for impairment each reporting period. For example, the communications entity may have to impair the asset if Customer B terminates the contract before the end of two years and it is unable to collect an early termination fee in excess of the contract asset balance. The simple example above does not address other complexities that entities will have to consider. An entity that charges an activation fee to customers will need to determine whether activation represents a separate performance obligation, or if it relates to the provision of future goods or services. If activation is not a separate performance obligation, and the entity grants the customer an option to renew that provides a material right (for example, an option to renew without requiring the customer to pay an additional activation fee), the activation fee would likely be recognised over the customer relationship period. Contract acquisition costs Telecom Communications entities often pay commissions to internal sales agents and third-party dealers for connecting new customers to their networks. Commissions paid for connecting new customers can vary depending on the length of the service contract and the type of service plan, including any enhanced services sold. The longer the service contract and the greater the monthly proceeds (for example, service plans with relatively high or unlimited minutes of use), the greater the commission costs. Some entities that report under IFRS capitalise customer acquisition costs as an intangible asset, while other communications entities, including most US communications entities, expense These materials were downloaded from Inform ( under licence.page 95 / 307

96 these costs as incurred. The standard will require communications entities to capitalise incremental costs of obtaining a contract if the costs are expected to be recovered. As a practical expedient, entities are permitted to expense these costs when incurred if the amortisation period would be less than one year. Some wireless entities also provide free or heavily discounted handsets to attract customers. Incentive programs will not be accounted for as customer acquisition costs under the revenue standard. A handset is a separate performance obligation and the cost of the handset is recognised as an expense when the performance obligation is satisfied (that is, when the handset is delivered to the customer). Communications entities offer a wide range of discounts and subsidies, using both their own and third-party dealer networks, and will have to assess the accounting for each different type of arrangement. Cable Cable television companies often incur costs to obtain and retain subscribers. Entities will need to consider the guidance on acquisition costs in determining whether they should be expensed, or capitalised and amortised over a specified period. Final standard Current US GAAP Current IFRS Entities will recognise as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs. The incremental costs of obtaining a contract are those costs that an entity would not have incurred if the contract had not been obtained. All other contract acquisition costs incurred regardless of whether a contract was obtained are recognised as an expense. The revenue standard permits entities to expense incremental costs of obtaining a contract when incurred if the amortisation period would be one year or less, as a practical expedient. Contract costs recognised as an asset are amortised on a systematic basis consistent with the pattern of transfer of the goods or services to which the asset relates. In some cases, the asset might relate to goods or services to be provided in future anticipated contracts (for example, service to be provided to a customer in the future if the customer US GAAP allows costs that are directly related to the acquisition of a contract that would not have been incurred but for the acquisition of that contract (incremental direct acquisition costs) to be deferred and charged to expense in proportion to the revenue recognised. Other costs such as advertising expenses and costs associated with the negotiation of a contract that is not consummated are charged to expense as incurred. Given the lack of definitive guidance under current IFRS, costs of acquiring customer contracts have been capitalised by some communications entities as intangible assets and amortised over the customer contract period, while other communications entities expense the costs when incurred. These materials were downloaded from Inform ( under licence.page 96 / 307

97 chooses to renew an existing contract). An impairment loss is recognised to the extent that the carrying amount of an asset exceeds: a. the amount of consideration to which an entity expects to be entitled in exchange for the goods or services to which the asset relates; less b. the remaining costs that relate directly to providing those goods or services. Entities may reverse impairments, under IFRS, when costs become recoverable; however, the reversal is limited to an amount that does not result in the carrying amount of the capitalised acquisition cost exceeding the depreciated historical cost. Entities are not permitted to reverse impairments under US GAAP. Potential impact - both IFRS and US GAAP The revenue standard will have a significant impact on entities that do not currently capitalise contract acquisition costs. Entities will likely have to develop systems, processes, and controls to identify and track incremental contract acquisition costs and to subsequently monitor the capitalised costs for impairment. Communications entities will capitalise these contract acquisition costs as an asset if they are recoverable and amortise them consistent with the pattern of when goods or services to which the asset relates are transferred to the customer. Entities will need to use judgement to determine the amortisation period as the revenue standard requires entities to consider periods beyond the initial contract period; for example, the renewal of existing contracts and anticipated contracts. Entities should carefully consider potential renewals in assessing the amortisation period for contract acquisition costs, including month-to-month service arrangements. While the revenue standard moves closer to aligning the recognition of costs with the associated revenue, differences may still exist. For example, upfront fees (such as activation fees, discussed briefly in Example 8 above) are deferred if they do not relate to a transfer of a These materials were downloaded from Inform ( under licence.page 97 / 307

98 promised good or service that represents a separate performance obligation. These fees could represent advance payments for goods and services provided under the contract, or they might provide the customer with a material right in the form of renewal option that extends beyond the initial contract period. Judgement will need to be exercised in determining the period over which the related revenue is recognised. As there is a practical expedient that allows contract acquisition costs to be recognised immediately if the deferral period is less than one year, the revenue recognition period will not necessarily correspond with the period over which contract acquisition costs are amortised. Entities will also have to develop a systematic approach, considering the number of customers and contract offerings, to test assets relating to contract acquisition costs for impairment (for example, a portfolio approach) when the estimated amount of consideration to be received from customers might be less than the outstanding contract asset. Spreading these costs over the amortisation period could significantly affect operating margins compared to the current accounting model. Wireless entities, for example, often incur significant contract acquisition costs during the holiday seasons as they sign up customers through significant promotional offers. Example 9 Contract acquisition costs, practical expedient Question: A communications entity enters into a contract with a customer to provide telecom services. The entity pays a third-party dealer a commission to connect customers to its network. The customer signs an enforceable contract to receive telecom services for one year. How should the communications entity account for the third-party dealer commission? Discussion: The entity will identify incremental contract acquisition costs and capitalise those costs that are recoverable. The communications entity may use the practical expedient and expense contract acquisition costs when incurred if the amortisation period would be one year or less. The entity determines the amortisation period is one year in this case after considering expected renewals. The communications entity may use the practical expedient and expense these costs when incurred. Example 10 Contract acquisition costs, identifying incremental costs Question: A communications entity sells wireless telecom service subscriptions (service plans) from a retail store in a shopping mall. Sales agents employed at the retail store sign 120 customers to two-year telecom service contracts in a particular month. The monthly rent for the store is C5,000. The communications entity pays the sales agents commissions for the sale of telecom service contracts, in addition to their normal wages. Wages paid to the sales agents during the month are C12,000 and commissions are C24,000. The communications entity also offers customers free, or significantly subsidised, handsets to create an incentive for them to enter into two-year contracts. The net subsidy (loss) on handsets sold to the 120 customers is C36,000 (measured simply on the basis of the cost of the handset compared to advertised price, and not as specified in the revenue standard). The retail store also incurs C2,000 in costs during the month to advertise in the local journals. How much should the communications entity recognise as a contract acquisition asset? Discussion: The communications entity is required to capitalise incremental costs to acquire contracts, which are those costs the entity would not have incurred unless it acquired the contracts. The practical expedient is not available as the amortisation period is greater than a year. In this example, the only costs that qualify as incremental contract acquisition costs are the C24,000 commissions paid to the sales agents. All other costs are charged to expenses when incurred. The store rent of C5,000, the sales These materials were downloaded from Inform ( under licence.page 98 / 307

99 agents wages of C12,000, and advertising expenses of C2,000 are all expenses the communications entity would have incurred regardless of acquiring the customer contracts and should be expensed as incurred. The entity might internally regard the handset losses as marketing incentives or incidental goods or services, but the sale of the handsets are performance obligations, and the costs of the handsets are recognised (as cost of goods sold) as the goods are delivered. Entities should be aware that subtle differences in arrangements could have a substantial impact on the accounting for subsidies and discounts under the revenue standard. For example, another communications entity might pay third-party dealers greater commissions to allow those dealers to offer similar incentives (that is, offer significantly discounted handsets at a dealer s discretion). Payments to dealers that are in-substance commissions should be treated as contract acquisition costs. Example 11 Contract acquisition costs, amortisation period for prepaid services Question: A communications entity sells wireless services to a customer under a prepaid, unlimited monthly plan. The communications entity pays commissions to sales agents when they activate a customer on a prepaid wireless service plan. While the stated contract term is one month, the communications entity expects the customer, based on the customer s demographics (for example, geography, type of plan, and age), to renew for six additional months. What period should the communications entity use to amortise the contract acquisition costs (that is, the commission costs)? Discussion: The entity could use the practical expedient to expense the costs as incurred. If the entity chooses to capitalise the costs, it will use judgement to determine an amortisation period that represents the period during which the entity transfers the telecom services. In this example, the entity determines an amortisation period of seven months based on anticipated renewals. Fulfilment costs Some communications entities defer the cost of activating customers to the network (that is, labour and equipment cost) under US GAAP. These costs can be material and are typically deferred up to the amount of related activation revenue and amortised on a straight-line basis consistent with the related revenues. Entities that provide long-term network outsourcing services sometimes defer set-up costs under IFRS because they are necessary investments to support the ongoing delivery of the contract. Costs to fulfil contracts are capitalised under the scope of other standards (for example, inventory, property, plant and equipment, or intangible assets) or if they meet specific requirements under the revenue standard. Entities will need to carefully review its cost capitalisation policies to understand the potential effect of these changes. Final standard Current US GAAP Current IFRS Direct costs incurred to fulfil a Costs incurred to install contract are first assessed to services at the origination of a determine if they are within the customer contract may be scope of other standards, in either expensed as incurred, which case the entity accounts or deferred and charged to for such costs in accordance expense in proportion to the with those standards. revenue recognised. Costs that are not in the scope of another standard are In particular, direct, incremental, set up costs on These materials were downloaded from Inform ( under licence.page 99 / 307 Costs incurred to install services at the origination of a customer contract are either expensed as incurred or they are recognised as an asset and charged to expense in proportion to the revenue recognised, depending on the nature of the costs.

100 evaluated under the revenue standard. An entity recognises an asset only if the costs: relate directly to a contract; generate or enhance resources that will be used in satisfying future performance obligations (that is, they relate to future performance); and are expected to be recovered. These costs are then amortised as control of the goods or services to which the asset relates is transferred to the customer. long-term network outsourcing contracts may be deferred by reference to the FASB Conceptual Framework and analogy to ASC and ASC In addition, many of the costs of connecting customers form part of the operator s network and the costs are capitalised as property, plant and equipment. In particular, direct, incremental, set up costs on long-term network outsourcing contracts may be deferred if they are costs that relate to future activity on the contract. Many of the costs of connecting customers form part of the operator s network and the costs are capitalised as property, plant and equipment. Potential impact - both IFRS and US GAAP Communications entities that currently expense all contract fulfilment costs as incurred might be affected by the revenue standard since costs are required to be capitalised when the criteria are met. Fulfilment costs that are likely to be in the scope of this guidance include, among others, set-up costs for service providers. Contract modifications Customers of communications entities often request changes to their service plans. For example, wireless telecom customers might change their existing service plans to upgrade or replace a device; include additional wireless minutes; increase data usage; add incremental, or remove, existing services; or terminate service altogether. Modifications also occur in multi-line plans when the customer adds, or removes a device and/or changes the size of the data plan being shared across devices. Entities will need to account for the changes as a modification to the contract as devices or services not covered under the original contract are added or removed. Contract modifications exist when the parties to the contract approve a modification that creates or changes the enforceable rights and obligations of the parties to the contract. Entities will need to apply judgement in evaluating whether goods or services in the modification are distinct to determine whether a contract modification should be accounted for prospectively or as a cumulative catch-up adjustment. This may be particularly challenging in situations where there are multiple performance obligations in a contract. These materials were downloaded from Inform ( under licence.page 100 / 307

101 Final standard Current US GAAP Current IFRS A contract modification is Modifications to add or remove Modifications to add or remove treated as a separate contract only if it results in the addition of a distinct performance obligation and the price goods or services in telecom arrangements are typically viewed as new arrangements with changes accounted for goods or services in telecom arrangements are typically viewed as new arrangements with changes accounted for reflects the stand-alone selling prospectively. prospectively. price of that performance obligation. Otherwise, the modification is accounted for as an adjustment to the original contract. An entity will account for a modification prospectively if the goods or services in the modification are distinct from those transferred before the modification. An entity will account for a modification through a cumulative catch-up adjustment if the goods or services in the modification are not distinct and are part of a single performance obligation that is only partially satisfied when the contract is modified. A contract modification that only affects the transaction price should be treated like any other contract modification. Potential impact - both IFRS and US GAAP Historically, modifications to communications contracts have typically been treated as a new agreement with changes accounted for prospectively. Going forward, entities will need to evaluate modifications under the new guidance to determine whether they are accounted for prospectively, or require a cumulative catch up adjustment. The analysis will need to consider modifications on new types of service plans, such as multi-line plans, where it may be more difficult to determine whether the modification adds distinct goods or services, or modifies existing goods or services being provided under the contract. The revenue standard states that an entity will account for a series of distinct goods or services that are substantially the same as a single performance obligation if certain criteria are met. This approach will likely be used by communications entities in applying the guidance to contracts that provide the customer with a consistent level of services on a monthly basis over a contract period, rather than to treating each month or each day of service as a separate performance obligation. Entities that account for a series of distinct goods or services in this manner at inception of the arrangement must consider the distinct goods or services in the contract (not the performance obligation) for purposes of applying the guidance on contraction modifications. Therefore, contracts where the remaining goods are services in the modified contract are distinct from goods or services that have already been transferred to the customer will be These materials were downloaded from Inform ( under licence.page 101 / 307

102 accounted for prospectively. Example 12 Contract modification Question: A fixed-line communications entity enters into a contract with a customer to provide voice and data services for 24 months at a fixed charge of C50 per month. After six months, the customer decides to add TV services for an incremental fee of C50 per month over the same term. This price is slightly lower than the price charged to customers who just purchase the TV service without voice and data services, which reflects the fact that the customer acquired the TV service as part of a bundle. In this scenario, assume there are no other fees or deliverables. How should the entity account for this modification? Discussion: The TV services added by the customer are a distinct performance obligation. These services are being charged at relative stand-alone selling price (as adjusted for the selling costs avoided by transacting with an existing customer). The TV services are a new contractual arrangement, and there is no impact to the accounting for the existing data and voice services. While this example is fairly simple, further complexities could arise with contract modifications. For example, the modification could provide the customer with a discount on new or existing services, the contract period could be extended for all services, or additional deliverables (such as equipment) could be introduced. Entities will have to carefully assess the facts and circumstances to ensure the guidance is appropriately applied to these complex situations. About PwC s Communications practice PwC s communications practice provides audit and assurance, business advisory, and tax services to communications entities around the globe including fixed, mobile, cable, satellite, and Internet service providers. We support our clients through industry restructurings, regulatory transformations, technological advances, and changes in financial reporting and corporate governance requirements. PwC helps organisations and individuals create the value they re looking for. We re a network of firms in 157 countries with more than 184,000 people who are committed to delivering quality in assurance, tax and advisory services. Retail and consumer industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for entities in the communications industry as they transition to the new standard. Overview These materials were downloaded from Inform ( under licence.page 102 / 307

103 Historically, the accounting for revenue recognition in the retail and consumer sectors has been governed by multiple pieces of literature under US GAAP and by a single revenue standard and the related interpretations under IFRS. The new revenue recognition standard introduces a new model for revenue recognition, and while it may not have a broad impact on some aspects of the retail and consumer industry, certain areas will be significantly affected. This is the case especially for US GAAP preparers, where, for example, certain aspects of product-based sales transactions that include customer incentives and loyalty programs will be affected. Arrangements in the retail and consumer sectors are often unique to the parties and the specific facts and circumstances should be evaluated closely when applying the new standard. Right of return Return rights are commonly granted in the retail and consumer industry and may take the form of product obsolescence protection, stock rotation, trade-in agreements, or the right to return all products upon termination of an agreement. Some of these rights may be articulated in contracts with customers or distributors, while others are implied during the sales process, or based on historical practice. New model Current US GAAP Current IFRS Revenue should not be recognised for goods Revenue is recognised at the time of sale if future returns expected to be returned, and a can be reasonably estimated. liability should be recognised for expected refunds to customers. The refund liability should be updated each Returns are estimated based on historical experience with an allowance recorded against sales. reporting period for changes in expected refunds. An asset and corresponding adjustment to cost of sales should be recognised for the right to recover goods from customers on settling the refund liability. The asset will be initially measured at the cost of inventory sold less any expected costs to recover the goods and the impact of any reduction in the value of those goods. At the end of each reporting period, the asset should be re-measured (if necessary) based on changes in expectations. The guidance for variable consideration is applied to determine how much revenue to recognise. Entities will recognise the amount of revenue they expect to be entitled to when control transfers to the extent it is highly probable' (IFRS) or probable' (US GAAP) that Revenue is not recognised until the return right lapses if an entity is unable to estimate potential returns. Potential impact: Revenue is typically recognised net of a provision for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an established historical record and other relevant evidence. Current IFRS does not specify the balance sheet accounting for expected returns. The accounting for product returns under the revenue standard will be largely unchanged from current guidance under IFRS and US GAAP. There might be some retail and consumer entities that are deferring revenue today because they are unable to reliably estimate returns. The new guidance requires that the impact of returns be estimated using a probabilityweighted approach or most likely outcome, whichever is most predictive. Consideration received included in revenue to the extent that it is highly probable under IFRS (probable under US GAAP) that there will be no significant reversal when the uncertainty is resolved. This could result in revenue being recognised earlier than under today's guidance. There is diversity in existing practice in the balance sheet presentation for expected returns. The revenue standard specifies that the balance sheet should reflect both the refund obligation and the asset for the right to the returned goods on a gross basis. These materials were downloaded from Inform ( under licence.page 103 / 307

104 significant reversal will not occur in the future. Exchanges of products for another of the same type, quality, condition and price are not considered returns. Defective product exchanges should be considered in accordance with the guidance on warranties. Example 1 - Right of return as a separate performance obligation Facts: A retailer sells 100 mobile phones for C100 each. The mobile phones cost C50 and the terms of sale include a return right for 180 days. The retailer estimated that 10 mobile phones would be returned based on historical sales patterns. In establishing this estimate, the retailer used an expected value method and estimated a 40% probability that eight mobile phones will be returned, a 45% probability that nine mobile phones will be returned, and a 15% probability that 18 mobile phones will be returned. The retailer also concludes it is probable (highly probable) that there will not be a significant reversal of revenue when the uncertainty is resolved. How should the retailer record the revenue and expected returns related to this transaction? Discussion: At the point of sale, C9,000 of revenue (C100 x 90 mobile phones) and cost of sales of C4,500 (C50 x 90 mobile phones) is recognised. An asset of C500 (cost of C50 x 10 mobile phones) is recognised for the anticipated return of the mobile phones (assuming they are returned in a re-saleable condition), and a liability of C1,000 (C100 x 10 mobile phones) is recognised for the refund obligation. The probability of return is evaluated at each subsequent reporting date. Any changes in estimates are adjusted against the asset and liability, with adjustments to the liability recorded to revenue and adjustments to the asset recorded against cost of sales. Sell-through approach/consignment arrangements The sell-through approach is used today for some arrangements with distributors where revenue is not recognised until the product is sold to the end customer (that is, the consumer) because the distributor may be able to return the unsold product, rotate older stock, or receive pricing concessions. As a result, the risks and rewards of ownership have not transferred. Some entities sell products using consignment arrangements under which the buyer (a dealer or distributor) takes physical possession of the goods, but does not assume all of the risks and rewards. New model Current US GAAP Current IFRS Revenue should be Revenue is recognised once recognised when a good or the risks and rewards of service is transferred to the ownership have transferred to customer. An entity transfers a the end consumer under the good or service when the sell-through approach. customer obtains control of that good or service. A Goods delivered to a customer obtains control of a consignee pursuant to a good or service if it has the consignment arrangement are ability to direct the use of and not considered sales, and do receive the benefit from the not qualify for revenue A contract for the sale of goods normally gives rise to revenue recognition at the time of delivery, when the following conditions are satisfied: The risks and rewards of ownership have These materials were downloaded from Inform ( under licence.page 104 / 307

105 good or service. Indicators that the customer has obtained control of the good or service include: The entity has a present right to payment for the asset. The customer has legal title to the asset. The entity transferred physical possession of the asset. The customer has the significant risk and rewards of ownership. The customer has accepted the asset. A product is held on consignment if the buyer has physical possession, but has not obtained control. An entity should not recognise revenue for products held on consignment. Indicators that there is a consignment arrangement include: recognition. Once it is determined that substantial risk of loss, rewards of ownership, as well as control of the asset have transferred to the consignee, revenue recognition would then be appropriate, assuming all other criteria for revenue recognition have been satisfied. transferred. The seller does not retain managerial involvement to the extent normally associated with ownership nor retain effective control. The amount of revenue can be reliably measured. It is probable that the economic benefit will flow to the customer. The costs incurred can be measured reliably. Revenue is recognised once the risks and rewards of ownership have transferred to the end consumer under the sell-through approach. Revenue is not recognised on consignment sales until performance has taken place. If the purchaser of goods on consignment has undertaken to sell the items on the seller's behalf, then revenue should not be recognised by the seller until the goods are sold to a third party. The product is controlled by the seller until a specified event, such as a sale to an end customer. The entity is able to require the Potential impact: The effect of the revenue standard on the sell-through approach and on consignment arrangements will depend on the terms of the arrangement. The new standard requires management to determine when control of the product has transferred to the customer. Revenue is recognised when the customer or distributor has control of the product, even if the terms include a right of return (that is, not when the product is transferred to the third-party). Expected returns or price concessions affect the amount of revenue, but not when revenue is recognised. These materials were downloaded from Inform ( under licence.page 105 / 307

106 return or transfer of the product. The dealer does not have an unconditional obligation to pay for the product. The timing of revenue recognition could change for some entities because today's guidance is focused on the transfer of risks and rewards rather than the transfer of control. The transfer of risks and rewards is an indicator of whether control has transferred under the new revenue standard, but additional indicators will also need to be considered. If the entity can require the customer or distributor to return the product (that is, it has a call right), control likely has not transferred to the customer or distributor; therefore, revenue is only recognised when the products are sold to a third party. The entity would continue to recognise the asset and account for any payments received from the customer as a financial liability. Example 2 - Sale of products to a distributor using a sell-through approach Facts: A consumer products entity uses a distributor network to supply its product to the end customer. The distributor receives legal title and is required to pay for the products upon receipt, but may return unsold product at the end of the contract term. Once the products are sold to the end customer, the consumer products entity has no further obligations for the product and the distributor has no further return rights. When does the consumer products entity recognise revenue? Discussion: Revenue is recognised once control of the product has transferred, which requires an analysis of the indicators of the transfer of control. The distributor has physical possession, legal title, a present obligation to pay for the asset, and the right to determine whether the goods are returned, which are all indicators that control transferred when the goods were delivered to the distributor. If control has transferred to the distributor and revenue is recognised, the consumer products entity would recognise a liability for expected returns. Note: If the consideration the entity receives is dependent on the sell-through price to the customer (or on the extent of any returns) and if it was determined that control transfers and revenue is recognised on transfer to the retailer, the guidance for variable consideration would be applied. Example 3 - Sale of products on consignment Facts: A manufacturer provides household goods to a retailer on a consignment basis (for example, scan-based trading). The manufacturer retains title to the products until they are scanned at the register. The retailer does not have an obligation to pay the manufacturer until a sale occurs and any unsold products may be returned to the manufacturer. The manufacturer also retains the right to call back or transfer unsold products to another retailer until the sale to the consumer. Once the retailer sells the products to the consumer, the manufacturer has no further obligations for the products, and the retailer has no further return rights. When does the manufacturer recognise revenue? Discussion: The manufacturer should recognise revenue when control has passed to the retailer, which requires an analysis of the indicators of the transfer of control. Although the retailer has physical possession of the products, it does not take title, does not have an unconditional obligation to pay the manufacturer and maintains a call right to the products. Therefore, control does not transfer and revenue is not recognised until the product is sold to the consumer. FOB synthetic destination These materials were downloaded from Inform ( under licence.page 106 / 307

107 Consumer products entities often have a customary practice of replacing or crediting lost or damaged goods even when sales contracts contain free on board' (FOB) shipping point terms, and the customer obtains control at the time of shipment. In such instances, the customer is in the same position as if the shipping terms were FOB destination. Revenue would likely be recognised when the product is received by the customer under today's guidance because the risks and rewards of ownership have not been substantively transferred to the customer at the point of shipment. The timing of revenue recognition might change under the new standard's control-based model. New model Current US GAAP Current IFRS Revenue should be recognised when a good or service is transferred to the customer, as described in the Sell-through approach. Situations where an entity transfers a good but retains the risk of loss or damage based on shipping terms could indicate an additional performance obligation exists that has not yet been fulfilled. Performance obligations are discussed further in the Customer incentives' section. Revenue from the sale of a good should not be recognised until the seller has substantially accomplished what it must do pursuant to the terms of the arrangement, which usually occurs upon delivery. The risks and rewards of ownership need to substantively transfer to the customer. Revenue is deferred until the goods have been delivered to the end customer if the vendor has established a practice of covering risk of loss in transit. Potential impact: A contract for the sale of goods normally gives rise to revenue recognition at the time of delivery, as described in the Sell-through approach. Revenue is typically recognised once the goods reach the buyer when there are FOB synthetic destination terms, as risks and rewards of ownership typically transfer at that time. The timing of revenue recognition could change under the new revenue standard as the focus shifts from transfer of risks and rewards to the transfer of control of the goods. The indicators of whether control has transferred would need to be assessed based on facts and circumstances. For example, a good may be shipped under FOB destination terms in which legal title does not transfer until delivery is completed. However, control may transfer upon shipment if the customer has the ability to sell the asset and re-direct delivery to its own customer while in transit. Management will also need to assess whether the shipping terms create an additional performance obligation when control transfers on shipment. Examples of this could be shipping and in-transit risk of loss coverage. Control of the underlying goods could be transferred and revenue recognised when the product leaves the seller's location, based on legal title transfer, the entity's right to receive payment, or the customer's ability to redirect and sell the goods, but there might be a second performance obligation for shipping and in-transit risk of loss. Management will need to allocate the transaction price to each of the performance obligations, and recognise revenue when each performance obligation is satisfied, which might be at different times. Management should consider the effect of these arrangements based on the facts and circumstances of each transaction. These materials were downloaded from Inform ( under licence.page 107 / 307

108 Example 4 - FOB synthetic destination Facts: An electronics manufacturer enters into a contract to sell flat screen televisions to a retailer. The delivery terms are free on board (FOB) shipping point (legal title passes to the retailer when the televisions are handed over to the carrier). A third-party carrier is used to deliver the televisions. The manufacturer has a past business practice of providing replacements to the retailer at no additional cost if the televisions are damaged during transit. The retailer does not have physical possession of the televisions during transit, but has legal title at shipment and therefore can redirect the televisions to another party. The manufacturer is also precluded from selling the televisions to another customer while in transit. Does the manufacturer have a separate performance obligation with respect to the risk of loss during transit? Discussion: The manufacturer might conclude that it has two performance obligations: one for fulfilling the order for the televisions and a second for covering the risk of loss during transit based on its past business practice. The manufacturer has not satisfied its performance obligation regarding risk of loss at the point of shipment. The consideration from the customer should be allocated to the televisions and to the service that covers the risk of loss. Revenue for the televisions is recognised at the time of shipping when control transfers. Revenue for covering the risk of loss is recognised over the period the goods are being transported. Customer incentives Retail and consumer entities offer a wide array of customer incentives. Retailers commonly offer coupons, rebates issued at the point of sale, free products ( buy-one-get-one-free'), price protection, or price matching programs to their customers. Consumer product entities commonly provide vendor allowances, including volume rebates and cooperative advertising allowances, market development allowances, and mark-down allowances (compensation for poor sales levels of vendor merchandise). Consumer product entities also offer product placement or slotting fees to retailers. Various pieces of guidance apply today and there is some diversity in practice in accounting for such incentives. Customer incentives can affect the amount and timing of revenue recognition in several ways. They can create additional performance obligations, which can affect the timing of revenue recognition, and they often introduce variability into the transaction price, which can affect the amount of revenue recognised. The new revenue standard includes specific guidance addressing these areas. The guidance for variable consideration in particular will apply to a wide range of customer incentives and is different from the existing guidance under IFRS and US GAAP. New model Current US GAAP Current IFRS Performance obligations The following criteria are considered to determine whether elements included in a multiple-element arrangement are accounted for separately: The revenue standard requires entities to identify all promised goods or services in a contract and determine whether to account for each promised good or service as a separate performance obligation. A performance obligation is a promise in a contract to The delivered item has value to the customer on a stand-alone These materials were downloaded from Inform ( under licence.page 108 / 307 The revenue recognition criteria are usually applied separately to each transaction. It might be necessary to separate a transaction into identifiable components to reflect the substance of the transaction in certain circumstances. Separation is appropriate when identifiable components have stand-alone value and their fair value can be measured reliably.

109 transfer a distinct good or service to a customer. A good or service is distinct and is separated from other obligations in the contract if both: the customer can benefit from the good or service separately or together with other resources; and the good or service is separable from other goods or services in the contract. basis. If a general return right exists for the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. Two or more transactions might need to be grouped together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. Options to acquire additional goods or services An entity may grant a customer the option to acquire additional goods or services free of charge or at a discount. These options may include customer award credits or other sales incentives and discounts that will give rise to a separate performance obligation if the option provides a material right that the customer would not receive without entering into the contract. The entity should recognise revenue allocated to the option when the option expires or when the additional goods or services are transferred to the customer. An option to acquire an additional good or service at a price that is within the range of prices typically charged for those goods or services does not provide a material right, even if the option can be When an option is determined to be substantive, an entity would need to evaluate whether that option has been offered at a significant incremental discount. If the discount in an arrangement is more than insignificant, there is a presumption that an additional deliverable is being offered which requires that a portion of the arrangement consideration be deferred at inception. Loyalty programs and gift cards are discussed in a separate section. The recognition criteria are usually applied separately to each transaction (that is, the original purchase and the separate purchase associated with the option). However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components as a single transaction in order to reflect the substance of the transaction. If an entity grants its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, the entity accounts for that option as a separate component of the arrangement, and therefore allocates consideration between the initial good or service provided and the option. These materials were downloaded from Inform ( under licence.page 109 / 307

110 exercised only because of entering into the previous contract. Consideration payable to a customer An entity needs to determine the transaction price, which is the amount of consideration it expects to be entitled to in exchange for transferring promised goods or services to a customer. Consideration payable by an entity to a customer is accounted for as a reduction of the transaction price unless the payment is for a distinct good or service that the customer transfers to the entity. Variable consideration The transaction price might include an element of consideration that is variable or contingent on the outcome of future events, including (but not limited to) discounts, rebates, price concessions, refunds, returns, credits, incentives, performance bonuses, and royalties. Variable consideration is estimated using either an expected value or most likely outcome, whichever provides the best estimate. Variable consideration is included in the transaction price to the extent it is highly probable' (IFRS) or probable' (US GAAP) that there will not be a significant revenue reversal in future periods when the uncertainty is resolved. Judgement will often be needed to determine whether it is highly probable or probable there will not be a significant reversal. The revenue standard provides Sales incentives offered to customers are typically recorded as a reduction of revenue at the later of the date at which the related sale is recorded by the vendor or the date at which the sales incentive is offered. Volume rebates are recognised as each of the revenue transactions that results in progress by the customer toward earning the rebate occurs. Potential impact: Sales incentives offered to customers are recorded as a reduction of revenue at the time of sale. Management uses its best estimate of incentives expected to be awarded to estimate the sales price. The potential impact of volume discounts is considered at the time of the original sale. Revenue from contracts that provide customers with volume discounts is measured by reference to the estimated volume of sales and the expected discounts. Revenue should not exceed the amount of consideration that would be received if the maximum discounts were taken if management cannot reliably estimate the expected discounts. Entities will need processes that identify the different performance obligations in each agreement and pinpoint when and how those obligations are fulfilled. Retailers often offer customers a right to purchase free or discounted goods or services in the future in connection with the sale of goods (for example, coupons toward additional purchases). These arrangements typically create additional performance obligations. Payments to customers may result in a reduction to revenue, similar to today's accounting model. Exceptions to current accounting have changed and now consider whether an entity receives a distinct good or service in exchange. Entities that defer revenue recognition under current guidance because the price is not reliably measurable (IFRS) or fixed or determinable (US GAAP) might be significantly affected by the revenue standard. In a situation where the price is fixed, but the entity has a history of granting concessions, entities would be required to recognise the minimum amount of revenue they expect to be entitled to when control transfers as long as it is highly probable' (IFRS) or probable' (US GAAP) that the amount is not subject to a significant reversal in the future. These materials were downloaded from Inform ( under licence.page 110 / 307

111 indicators that might suggest such a reversal would take place. The evaluation of variable consideration will require judgement in many cases. Some entities will need to recognise revenue before all contingencies are resolved, which might be earlier than under current practice. Management might need to put into place new processes to monitor estimates on an ongoing basis as more experience is obtained. Example 5 - Retailer issued coupons Facts: Retailer sells goods to Customer for C100,000 and at the same time provides a coupon for a 60% discount off a future purchase during the next 90 days. Retailer intends to offer a 10% discount on all sales as part of a promotional campaign during the same period. Retailer estimates that 75% of customers that receive the coupon will exercise the option for the purchase of, on average, C40,000 of discounted additional product. How should Retailer account for the option provided by the coupon? Discussion: Retailer should account for the option as a separate performance obligation, as the discount represents a material right. It is a material right because it is incremental to the discount offered to a similar class of customers during the period (only a 10% discount is offered more widely). The stand-alone selling price of the option is C15,000, calculated as the estimated average purchase price of additional products (C40,000) multiplied by the incremental discount (50%) multiplied by the likelihood of exercise (75%). The transaction price allocated to the discount based on its relative stand-alone selling price will be recognised upon exercise (that is, upon purchase of the additional product) or expiry. An entity should consider whether it needs to assume 100% redemption of the options if it does not have sufficient history to estimate the extent of redemption. Example 6 - Manufacturer issued coupons Facts: A manufacturer sells 1,000 boxes of laundry detergent to a retailer for C10 per box. Control transfers when the product is delivered to the retailer. There are no return rights, price protection, stock rotation or similar rights. The retailer sells the laundry detergent to consumers for C12 per box. The manufacturer simultaneously issues coupons directly to consumers via newspapers which are valid for the next six months and provide a C1 discount on each box of detergent purchased. The coupons are presented by the consumer to the retailer upon purchase of the detergent. The retailer submits coupons to the manufacturer and is compensated for the face value of the coupons (C1). Using the expected value method (which the manufacturer believes is most predictive of the consideration it will be entitled to), the manufacturer estimated that 400 coupons will be redeemed. The manufacturer has recent experience with similar promotions involving similar pricing and discounting levels. Therefore, it concludes it is highly probable (IFRS) or probable (US GAAP) that the actual number of coupons redeemed will not result in a significant reversal of the cumulative revenue recognised. How much revenue should the manufacturer and retailer recognise? Discussion: The manufacturer will recognise C9,600 of revenue (C10,000 less estimated coupon redemptions of C400) for detergent sold to the retailer. While the retailer's accounting in this scenario is not specifically addressed by the new standard, we generally believe the additional consideration paid by the manufacturer is revenue to the retailer, as the fair value of the total consideration received by the retailer is C12. Following this logic, the retailer will recognise revenue of C12 and cost of sales of C10 for each box upon sale to the consumer, whether or not they present a coupon. Cost of sales remains at the original amount paid by the retailer to the manufacturer. Example 7 - Free product rebate These materials were downloaded from Inform ( under licence.page 111 / 307

112 Facts: A vendor is running a promotion whereby a consumer who purchases three boxes of golf balls at C20 per box in a single transaction receives an offer for one free box of golf balls if the customer fills out a request form and mails it to the vendor before a set expiration date (a mail-in rebate). The vendor estimates, based on recent experience with similar promotions, that 80% of the customers will complete the mail-in rebate required to receive the free box of golf balls. How is the consideration allocated to the various deliverables in the arrangement? Discussion: The purchase of three boxes of golf balls gives the customer the right to the fourth box for free. This is a material right, which is accounted for as a separate performance obligation. The transaction price is allocated to the right using relative stand-alone selling price, which considers estimated redemptions. Therefore, the value of the option is C16 (C20 x 100% discount x 80% expected redemption). Management would allocate C12.63 (C60 x (C16 / (C16 + C60))) of the transaction price to the mail-in rebate. The vendor recognises revenue of C47.37 when the three boxes of golf balls are sold, assuming control transfers, and recognises a liability for C12.63 until the rebate is redeemed or expires unredeemed. If the vendor is unable to determine the number of mail-in rebates that will be used, management would assume 100% redemption. Management would allocate C15 (C60 x (C20 / (C20 + C60))) to the undelivered box and recognise revenue on delivery following redemption, expiration of the rebate or until it is able to make an estimate. Example 8 - Slotting fees Facts: A manufacturer sells products to a retailer for C8 million. The manufacturer also makes a C1 million non-refundable upfront payment to the retailer for favourable product placement. How does the manufacturer account for the upfront payment? How does the retailer account for the upfront payment? Discussion: The product placement services cannot be sold separately. The service is not distinct because the manufacturer would not obtain any rights or receive any benefit without selling products to the retailer. The manufacturer recognises a reduction in the transaction price of C1 million and recognises C7 million in revenue when control of the products transfers to the retailer. From the retailer's perspective, the C1 million upfront payment for product placement services is not a payment for satisfying a distinct performance obligation and should be recognised as a reduction of cost of goods sold. Example 9 - Price protection if competitor subsequently lowers price Facts: A retailer sells a product to customer A for C100 on January 1 and agrees to reimburse customer A for the difference between the purchase price and any lower price offered by a certain direct competitor during the three-month period following the sale. The retailer has recent experience with similar promotions of similar products. On a probability-weighted basis, the retailer estimates it will reimburse the customer C5. How does the retailer account for the potential refund? Discussion: The consideration expected to be repaid to the customer is excluded from revenue and recorded as a liability at the time of sale. Management concludes based on its recent experience that it is highly probable under IFRS (or probable under US GAAP) that recognising C95 would not result in significant reversal of cumulative revenue upon resolution of the uncertainty. Therefore, the retailer recognises revenue of C95 and a refund liability of C5. Loyalty programs Retailers often use customer loyalty programs to build brand loyalty and increase sales volume by providing customers with incentives to buy their products. Each time a customer buys goods or services, or performs another qualifying act, the retailer grants the customer award credits. These materials were downloaded from Inform ( under licence.page 112 / 307

113 The customer can redeem the credits for awards such as free or discounted goods or services. The award credits are a separate performance obligation. New model Current US GAAP Current IFRS An option to acquire additional goods or services gives rise to a separate performance obligation if the option provides a material right that the customer would not receive without entering into that contract. The revenue standard requires management to estimate the transaction price to be allocated to the separate performance obligations and to recognise a contract liability for the performance obligations that will be satisfied in the future. There is divergence in practice in US GAAP in the accounting for loyalty programs. Two models commonly followed are an incremental cost accrual model and a multipleelement revenue model. The customer is paying for the future goods or services to be received when the award credits are issued in conjunction with a current sale. The entity recognises revenue for the option when those future goods or services are transferred to the customer or when the option expires. Under the incremental cost model, revenue is typically recognised at the time of the initial sale and an accrual is made for the expected costs of satisfying the award credits. The multiple-element model results in the transaction price being allocated to the products or services sold and to the award credits, with revenue recognised as each element is delivered. The incremental cost model is more prevalent in practice. Potential impact: Loyalty programs are accounted for as multipleelement arrangements. Some revenue, based on the fair value of award credits, is deferred and recognised when the awards are redeemed or expire. Revenue is allocated between the good or service sold and the award credits, taking into consideration the fair value of the award credits to the customer. The assessment of fair value includes consideration of discounts available to other buyers absent entering into the initial purchase transaction and expected forfeitures. The new revenue standard is consistent with the multipleelement model currently required under IFRS, but may have a greater impact on US GAAP reporters. The transaction price is allocated between the product and the loyalty reward performance obligations based on relative stand-alone selling price. The amount allocated to the loyalty rewards is recognised as a contract liability and revenue is recognised when the rewards are redeemed or expire. This will generally result in later revenue recognition for a portion of the transaction price for those currently using an incremental cost model. Example 10 - Loyalty points Facts: A retailer has a loyalty program that rewards customers one point per C1 spent. Points are redeemable for C0.10 off future purchases (but not redeemable for cash). A customer purchases C1,000 of product at the normal selling price and earns 1,000 points redeemable for C100 off future purchases of goods or services. The retailer expects redemption of 950 points (that is, 5% of points will expire unredeemed). The retailer therefore estimates a stand-alone selling price for the incentive of C0.095 per point based on the likelihood of redemption (C0.10 less 5%). How is the consideration allocated between the points and the product? Discussion: The retailer would allocate the transaction price of C1,000 between the product and points based on the relative stand-alone selling prices of C1,000 for the product and C95 for the loyalty reward as follows: These materials were downloaded from Inform ( under licence.page 113 / 307

114 Product Points C913 (C1,000 x C1,000/C1,095) C 87 (C1,000 x C95/C1,095) The revenue allocated to the product is recognised upon transfer of control of the product and the revenue allocated to the points is recognised upon the earlier of the redemption or expiration of the points. The estimate of the number of awards that will expire unredeemed is updated at each period end. Gift cards The use of gift certificates and gift cards is common in the retail industry. The gift cards or certificates are typically sold for cash and may be used by customers to obtain products or services in the future up to a specified monetary value. The amount of gift certificates that are forfeited is commonly referred to as breakage. Breakage will typically result in the recognition of income for a retailer; however, the timing of recognition depends on expected customer behaviour and the legal restrictions in the relevant jurisdiction. Final standard Current US GAAP Current IFRS When a customer purchases a When the gift card is sold to gift card, it is pre-paying for goods or services to be delivered in the future. The vendor has an obligation to transfer, or stand ready to transfer, the goods or services in the future creating a the customer, a liability is recognised for the future obligation of the retailer to honour the gift card. The liability is relieved (and revenue recognised) when the gift card is redeemed. performance obligation. The vendor should recognise a Currently, three accounting contract liability for the amount models are generally accepted of the prepayment and derecognise the liability (and recognise revenue) when it fulfils the performance obligation. for the recognition of breakage, depending on the features of the program, legal requirements and the vendor's ability to reliably estimate breakage: Expected breakage (that is, the customer's unexercised right) should be estimated and recognised as revenue in proportion to the pattern of rights exercised by the customer. The guidance for variable consideration is followed when estimating breakage. If the entity is unable to estimate the breakage amount, revenue for the unused portion of the gift card is recognised when the likelihood of the customer exercising its remaining rights becomes remote. If an entity is required to remit consideration to a third-party, such as a government body responsible for unclaimed proportional model - recognise as redemptions occur; liability model - recognise when the right expires; and remote model - recognise when it becomes remote that the holder of the rights will demand performance. These materials were downloaded from Inform ( under licence.page 114 / 307 Payment received in advance of future performance is recognised as revenue only when the future performance to which it relates occurs. That is, revenue from the sale of a gift card or voucher is accounted for when the seller supplies the goods or services upon exercise of the gift card. No specific models are provided for recognising breakage. The models used under US GAAP are acceptable under IFRS.

115 property, based on a customer's unexercised rights, then the entity should not recognise revenue related to unexercised rights. Where escheat laws apply, the vendor cannot recognise breakage revenue for escheatable funds since it is required to remit the funds to a third party even if the customer never demands performance. Potential impact: Similar to today's accounting model, entities will continue to recognise a contract liability for the obligation to deliver goods and services. Revenue is recognised when the gift card is redeemed or when the likelihood of the customer redeeming the gift card becomes remote. The specific guidance for breakage in the revenue standard should eliminate the diversity in practice that exists today. Example 11 - Gift cards/breakage Facts: A customer buys a C100 gift card from a retailer, which can be used for up to one year from the date of purchase. Using the guidance for variable consideration and its history of issuing gift cards, the retailer estimates that the customer will redeem C90 of the gift card and that C10 will expire unused (10% breakage). The entity has no requirement to remit any unused funds to the customer or any third party when the gift card expires unused. A contract liability of C100 is recorded upon sale of the gift card. How is revenue recognised when the gift card is redeemed? Discussion: For every C1 of gift card redemptions, the retailer recognises C1.11 (C1.00 x C100/C90) of revenue with C0.11 of the revenue reflecting breakage. For example, if the customer purchases a C50 product using the gift card, the retailer recognises C55 of revenue, reflecting the product's selling price and the estimated breakage of C5. Licences and royalties Licences are common in the retail and consumer sector. Many products include a licensed image or name. Retail and consumer companies may also license their trade names to others. Accounting for licences under the revenue standard may be different compared to today. New model Current US GAAP Current IFRS Licences are either a promise to provide a right, which transfers at a point in time, or a promise to provide access to an entity's intellectual property, which transfers over time. The key consideration in determining the revenue recognition pattern is therefore whether the licence provides a customer a right to access an Consideration is allocated to the licence and revenue is recognised when earned and realised or realisable. Revenue is generally earned at either the beginning or throughout the licence term, depending upon the nature of the licence and any other obligations of the licensor. Royalty revenue is generally recognised when realised or Revenue is not recognised under licensing agreements until performance occurs and the revenue is earned. The assignment of rights for a non-refundable amount under a non-cancellable contract permits the licensee to use those rights freely and where the licensor has no remaining obligations to perform is, in substance, a sale. A fixed These materials were downloaded from Inform ( under licence.page 115 / 307

116 entity's IP or a right to use an entity's IP. A licence provides a right to access IP when it provides the customer with access to the IP as it exists throughout the licence period. The IP to which the customer has access might change over time based on actions of the licensor. A customer will therefore not be able to direct the use of and obtain substantially all of the remaining benefits from the licence at the time of initial transfer. A licence provides a right to use IP when the customer receives IP that does not change after the licence transfers to the customer. The boards established three criteria to distinguish licences that are rights to access IP from those that are rights to use IP. Licences that meet all of these criteria provide access to IP and revenue should be recognised over time: realisable. licence term is an indicator that the revenue should be recognised over the period because the fixed term suggests that the licence's risks and rewards have not been transferred to the customer. However, the following indicators should be considered to determine whether a licence fee should be recognised over the term or upfront: Fixed fee or nonrefundable guarantee. The contract is noncancellable. Customer is able to exploit the rights freely. Vendor has no remaining performance obligations. Royalties are recognised on an accrual basis in accordance with the relevant agreement's substance. The licensor will undertake activities that significantly affect the IP to which the customer has rights. The rights granted by the licence directly expose the customer to any effects (both positive and negative) of those activities on the IP. The Potential impact: The new guidance for licences is different from today's models, so the timing of revenue recognition might change depending on the model currently followed. An entity should first consider the guidance for distinct performance obligations to determine if the licence is distinct from other goods or services in the arrangement. Licences that are not distinct are combined with other goods and services in the contract to identify a distinct performance obligation. Revenue is recognised when that performance obligation is satisfied. Complex arrangements, which include licences and other performance obligations, will require careful consideration to determine whether the licence should be accounted for separately. The next step for distinct licences is to determine whether the licence provides access, in which case revenue is recognised over time, or a right to use an entity's IP, in which case revenue is recognised when control has transferred to the licensee and the licence period has begun. Licensors may have to perform a much more detailed assessment than previously to determine the nature of the licence and when revenue is recognised. These materials were downloaded from Inform ( under licence.page 116 / 307

117 licensor's activities do not otherwise transfer a good or service to the customer as they occur. Licences of IP that involve variable consideration due to salesor usage-based royalties are subject to specific guidance about the transaction price. Consideration from the licence of IP that is based on a sales- or usage-based royalty is excluded from the transaction price until the sale or usage occurs. Entities will need to consider whether their licence arrangements fall within this guidance. The following factors should not be considered to determine whether a licence provides access or transfers a right: Restrictions of time, geography, or use, as these are attributes of the licence and do not define how the performance obligation is satisfied. For example, a term licence could be a right to access or use IP depending on the arrangement. Guarantees that the licensor has a valid patent and will defend the licensed IP from infringement, as these guarantees protect the value of the IP licensed by the customer. If a licensing arrangement has multiple deliverables, an entity should consider whether the These materials were downloaded from Inform ( under licence.page 117 / 307

118 licence is a separate performance obligation or whether it should be combined with other performance obligations. The transaction price in a licensing arrangement might include an element of consideration that is variable or contingent on the outcome of future events, such as a royalty. In most instances, variable consideration is included in the transaction price to the extent it is highly probable' (IFRS) or probable' (US GAAP) that there will not be a significant revenue reversal in future periods when the uncertainty is resolved. However, there is an exception in the case of salesor usage-based royalties from the licence of IP. Sales- or usage-based royalties from licences of IP are not included in the transaction price until they are no longer variable (that is, when the customer's subsequent sales or usage occur). The exception is limited to sales- or usagebased royalties arising from the licence of IP and does not apply to other royalty arrangements. Revenue cannot be recognised before the beginning of the period during which the customer can use and benefit from the licensed intellectual property, notwithstanding when the licence is transferred. Example 12 - Licences Facts: A designer of jeans has a worldwide recognised brand. A global manufacturer of dolls contracts with the designer for the right to use its brand name on the dolls' clothes. The terms of the agreement provide the doll manufacturer with rights to use the brand name on the dolls' clothes for two years. The designer will receive C1 million upfront and 12% of all proceeds from the sales of the dolls that include branded jeans. The doll manufacturer will provide updated These materials were downloaded from Inform ( under licence.page 118 / 307

119 sales estimates on a quarterly basis and actual sales data on a monthly basis. When does the designer recognise revenue? Discussion: The licence is a distinct performance obligation and is a right to access IP transferred over time. There is a reasonable expectation that the designer will undertake activities that will significantly affect the brand name to which the doll manufacturer has rights and the doll manufacturer is directly exposed to any positive or negative effects of the jeans' brand throughout the licence period. The upfront payment of C1 million is recognised as the performance obligation is satisfied, which is over time. The variable consideration to be received by the designer depends on the level of sales of dolls and is a sales-based royalty arrangement. Therefore, this component of the consideration is excluded from the transaction price until the sales have occurred. Warranties Products are often sold with standard warranties that provide protection to the consumer that the product will work as intended for a fixed period of time. Many entities also offer extended warranties that cover defects that arise after the initial warranty period has expired. Standard warranties have historically been accounted for as a cost accrual while extended warranties result in the deferral of revenue. The revenue standard draws a distinction between product warranties that the customer has the option to purchase separately (for example, warranties that are negotiated or priced separately) and product warranties that the customer does not have the option to purchase separately. Management will need to exercise judgement when assessing a warranty that is not sold separately to determine if there is a service component embedded in the warranty that should be accounted for as a separate performance obligation. New model Current US GAAP Current IFRS A warranty that can be purchased separately should be accounted for as a separate performance obligation because the entity promises a service to the customer in addition to the product. If a customer does not have the option to purchase a warranty separately, the entity should account for the warranty in accordance with other existing guidance on product warranties. A promised warranty, or a part of the promised warranty, which is not sold separately but provides the customer with a service in addition to the assurance that the product complies with agreed specifications, creates a performance obligation for the promised service. An entity that cannot Warranties are commonly included with product sales. Such warranties may be governed by third-party regulators depending on the nature of the product. Estimates of warranty claims are accrued at the time of sale for the estimated cost to repair or replace covered products for standard warranties. Extended warranties result in the deferral of revenue for the value of the separately priced extended warranty. The amount deferred is amortised to revenue over the extended warranty period. These materials were downloaded from Inform ( under licence.page 119 / 307 Management must determine if the warranty obligation is a separate element in the contract. When a warranty is not a separate element, and it represents an insignificant part of the transaction, the seller has completed substantially all of the required performance and can recognise the consideration received as revenue at the time of sale. The expected future cost relating to the warranty is recorded as a cost of sale, as the warranty does not represent a return of a portion of the sales price. Expected warranty costs are determined at the time of sale, and a provision is recognised. If the cost of providing the warranty service cannot be measured reliably, no revenue is recognised prior to the expiration of the warranty obligation.

120 reasonably separate the service component from a standard warranty should account for both together as a separate performance obligation. The consideration for sale of extended warranties is deferred and recognised over the period covered by the warranty. When the extended warranty is an integral component of the sale (that is, bundled into a single transaction), management ascribes a relative fair value to each component of the bundle. Potential Impact Extended warranties create separate performance obligations under the new revenue standard. Therefore, revenue is recognised over the warranty period. This is similar to existing guidance. Warranties that are separately priced might be affected as the transaction price will be allocated based on relative stand-alone selling prices rather than at the contract price. It may be difficult to separate standard warranties from those that also provide a service in some situations. Determining the estimated standalone selling price for the latter category when such warranties are not sold separately could also be challenging. The contract liability for extended warranties might be different from current guidance. Product warranties that are not sold separately and that provide for defects at the time a product is shipped will result in a cost accrual similar to current guidance. Example 13 - Warranty cost accrual Facts: A manufacturer sells stereo equipment. The manufacturer also provides a 60-day warranty that covers certain components of the stereo equipment. The warranty is not sold separately by the entity. How should the manufacturer account for the warranty? Discussion: The manufacturer should accrue the cost it expects to incur to satisfy the warranty similar to existing provisions (IFRS) or contingency (US GAAP) guidance. Example 14 - Warranty separate performance obligation Facts: A manufacturer sells stereo equipment. A customer has elected to also purchase the optional 12-month extended warranty. How should the manufacturer account for the warranty? Discussion: The manufacturer should treat the 12-month warranty as a separate performance obligation. A portion of the transaction price is allocated to the warranty based on its relative stand-alone selling price and is recognised as revenue when the warranty obligation is satisfied. The manufacturer will need to assess the pattern of warranty satisfaction to determine when revenue is recognised (that is, ratably or some other pattern). About PwC's Retail & Consumer practice Within PwC we have combined both retail and consumer-oriented companies into one practice group. Drawing on the talents of approximately 15,000 partners and professional staff worldwide These materials were downloaded from Inform ( under licence.page 120 / 307

121 dedicated to serving clients within the R&C sector, we help companies to solve complex business problems and measurably enhance their ability to build value, manage risk and improve performance in an internet-enabled world by providing industry-focused assurance, tax, and advisory services. Our R&C practice is a leading financial accounting, tax and advisory consulting business. Our experience cuts across all geographies and all segments of the R&C sector, serving the food & beverage, health & beauty care, tobacco & confectionery and other consumer products manufacturers, as well as a broad spectrum of retailers to include food, drug, mass merchandisers and specialty retailers. Our combined R&C practice allows us to understand issues across the entire supply chain, from source to sale, and to easily transfer our knowledge to clients related to attesting to and ensuring the accuracy of financial statements and reporting systems, providing local, state and global tax and compliance advice, managing and mitigating enterprise risk, improving business processes and operations, implementing technologies and helping clients with mergers and acquisitions to drive growth and improve profitability. Questions? PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in Accounting Consulting Services. Automotive industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for entities in the Automotive sector as they transition to the new standard. Other supplements present the impact of the new standard in other industrial sectors, including Industrial Products, Aerospace and Defence, and Engineering and Construction. Overview Entities in the automotive industry, including suppliers, dealers, original equipment manufacturers (OEMs) and their finance affiliates, will be affected by the new revenue standard, which replaces all current IFRS and US GAAP revenue recognition guidance. Key areas of interest to companies in the automotive industry include the accounting for pre-production activities (for example, pre-production design and tooling arrangements), marketing incentives (for example, cash rebates), volume rebates, repurchase options, product warranties, contract costs, and lease financing arrangements. This automotive industry supplement discusses the areas where the new standard is expected to have the greatest impact or be of particular interest to activities in the automotive industry. References to the new model, new guidance, and new standard throughout this document These materials were downloaded from Inform ( under licence.page 121 / 307

122 refer to the final standard unless otherwise indicated. Defining the contract The new standard applies only to contracts with customers. A contract is an agreement between two or more parties that creates enforceable rights and obligations. A contract does not exist if both parties have the unilateral right to terminate a wholly unperformed contract without penalty. Entities need to determine whether they should account for two or more contracts with the same customer together. Combining contracts, when appropriate, helps to ensure that the unit of accounting is properly identified, and the model is properly applied. For example, automotive suppliers often incur costs related to tooling prior to production of automotive parts. In some cases, the tooling is built by the supplier for sale to the OEM (that is, the tooling is or will be owned by the OEM). In others, the tooling will belong to the supplier. There is often a separate contract for both the construction of the tooling and the follow-on production output. Contract modifications are common in the automotive industry and come in a variety of forms, including changes in the amount of goods to be transferred or previously agreed pricing. Contract modifications might need to be accounted for as a new contract, or combined and accounted for together with the existing contract. It is not uncommon, for example, for an entity to receive price concessions on existing contracts in connection with the negotiation of new contracts. Entities need to evaluate whether a price concession is a modification of a previous contract or if it relates to a new contract. The entity might need to account for the price concession as part of a new contract and recognise the associated revenue as the performance obligations in the new contract are satisfied, as illustrated in Example 3. New model Current US GAAP Current IFRS Combining contracts Two or more contracts (including contracts with parties related to the customer) should be combined and accounted for as one contract if the contracts are entered into at or near the same time and: the contracts are negotiated with a single commercial objective; the amount of consideration in one contract depends on the price or performance of the other Combining contracts that are not in the scope of certain industry-specific guidance (for example, construction accounting) is required if they are with the same or related entities and are negotiated at the same time. Combining contracts that are not in the scope of certain industry-specific guidance (for example, construction accounting) is required when two or more transactions are linked and combination is necessary to reflect the commercial (that is, economic) substance of the transactions. These materials were downloaded from Inform ( under licence.page 122 / 307

123 contract; or the goods or services promised are a single performance obligation. Contract modifications A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services; and the price of the contract increases by an amount of consideration that reflects the standalone selling price of the additional promised goods or services. There is no clear guidance on accounting for contract modifications within the nonindustry-specific revenue guidance. Many entities account for contract modifications prospectively unless the contract modification is explicitly tied to prior performance. There is no clear guidance on accounting for contract modifications. Many entities account for contract modifications prospectively unless the contract modification is explicitly tied to prior performance. A modification that is not a separate contract is evaluated and accounted for either as: a termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification; or a cumulative adjustment to Non-refundable payments associated with accommodation arrangements (for example, price concessions) typically do not represent the culmination of a separate earnings process and should generally be deferred, similar to the accounting for an upfront fee. Non-refundable payments associated with accommodation arrangements (for example, price concessions) might need to be linked to another arrangement in order to understand their commercial effects and should generally be deferred, similar to the accounting for an upfront fee. These materials were downloaded from Inform ( under licence.page 123 / 307

124 contract revenue if the remaining goods and services are not distinct and are part of a single performance obligation that is partially satisfied. Potential impact: Although identification of the contract is not expected to be difficult, this step could result in changes in the automotive industry. Certain arrangements (for example, contracts for preproduction activities related to contracts for long-term supply arrangements) might need to be considered together as a single contract for accounting purposes (see discussion below regarding separately accounting for two or more performance obligations and allocating the transaction price). Combining contracts could result in a change in the allocation and pattern of revenue recognition compared to today s accounting. Contract modifications will continue to require judgement to determine whether they should be accounted for as a separate contract. The new standard provides more prescriptive guidance than current IFRS or US GAAP on determining whether a modification should be accounted for prospectively or as a cumulative catch-up adjustment. Example 1 - Combining contracts (separate contracts for tooling and production) Facts: A supplier enters into two contracts in the same week with an OEM to (1) construct a tool for the OEM (the Tool ) and (2) supply the OEM parts using the Tool. Title of the Tool transfers to the OEM prior to production of the parts under the supply contract, and the supplier will recover its cost for the Tool through a separate payment from the OEM equal to the supplier s cost of the Tool. Payment for the Tool is due upon completion of the Tool and its approval by the OEM. Should the supplier combine the contract to construct the Tool with the contract to produce the parts using the Tool? Discussion: Given that the two contracts were entered into near the same time, thesupplier will need to combine the two contracts if: (1) they were negotiated as a single package with a single commercial objective, (2) the consideration under one contract is dependent on the pricing of the other, or (3) the goods promised under the two contracts are a single performance obligation. In this example, it appears that the two contracts were negotiated with a single commercial objective (constructing the Tool and providing the related parts that will be produced using it) and that pricing is related (no profit margin on the Tool). The supplier should combine the two contracts based on the facts presented. Refer to Example 5 for a discussion of whether the Tool and production of the parts are a single performance obligation. Example 2 - Contract modification (change in volume and price) Facts: A supplier and an OEM have an existing take-or-pay contract for the sale of 1,000 parts at $10 each, with a total contract value of $10,000. The OEM purchases 600 parts but later These materials were downloaded from Inform ( under licence.page 124 / 307

125 concludes it needs not only the original 1,000 parts, but an additional 500 parts. The two parties negotiate a change in volume from 1,000 parts to 1,500 parts, and a prospective change in the price of all unproduced units from $10 to $7.50 (i.e., 900 remaining parts at $7.50 each). Assume the supplier does not offer similar discounts to other OEMs on similar parts sold. Should the contract modification be combined with the existing contract or accounted for as a separate contract? Discussion:The undelivered units are distinct (based on the definition of distinct in the new standard) from the delivered units and the pricing of the incremental units is not at current market prices (as implied by the above facts). Therefore, the modification should be accounted for as a termination of the existing contract and the creation of a new contract. The modification is accounted for prospectively in this fact pattern because the 600 delivered units are distinct from the 900 undelivered units. The supplier recognizes revenue of $7.50 per unit as control of each part transfers to the OEM. Revenue recorded for the first 600 parts sold is not adjusted. Example 3 - Accommodation arrangement (customer payment to compensate for lower than expected volume) Facts:A supplier and an OEM have an existing one year contract for the sale of parts at $10 each. The supplier and the OEM expected a volume of approximately 1,000 units when they entered into the contract, but the contract does not include a minimum volume commitment and the OEM is under no obligation to pay any additional consideration to the supplier. The OEM only purchased 600 parts and, at the end of the contract, the OEM agrees to pay the supplier $800 ((1,000 expected parts less 600 parts sold) x $2 (expected profit margin)) in the form of a non-refundable payment to make the supplier whole for the lower than expected volumes. At the same time, the supplier negotiates a new one year contract with the OEM for parts to be delivered in the following year at a per piece price of $10 based on the expectation that the OEM will purchase 900 parts over the second contract period. How should the supplier account for the non-refundable payment received? Discussion:While the new standard is not clear, the accounting for a contract modification provides reasonable guidance by analogy. If the $800 payment together with the $10 per unit price reflects the current market price for 900 units, the new arrangement is accounted for as a new contract. Otherwise, the arrangement is not a separate contract under the modification guidance because the second contract is not priced at market when considering the $800 payment on the first contract. The arrangement is nevertheless accounted for prospectively for the 900 parts under the new contract given that those parts are distinct from those sold under the original contract. Therefore, in this case, the non-refundable make whole payment will be allocated as part of the transaction price under the second contract. This means that revenue of $10.89 (($800 non-refundable payment + (900 parts x $10)) / 900 expected parts) is recognized as control of each part manufactured under the second contract is transferred to the OEM. Example 4 - Contract modification (addition of a good or service) Facts:An OEM sells vehicles to dealers with a promotion of three years of free maintenance on each vehicle to assist the dealer with selling the vehicles to the end customer. The promotion also applies to all vehicles on dealer lots for no additional charge to the dealer. The transaction with the dealer qualifies as a sale because control of the vehicle transfers to the dealer when the vehicle is delivered. Should the addition of free maintenance be accounted for as a sales incentive or as a performance obligation? Is there a different treatment for vehicles currently in dealer inventory versus new sales to dealers after the incentive is announced? Discussion: Free maintenance included as part of contracts for new sales to dealers is a performance obligation and a portion of the total transaction price should be allocated to it. These materials were downloaded from Inform ( under licence.page 125 / 307

126 With respect to inventory on dealer lots, the answer depends on whether there was a valid expectation by the dealer that the OEM would offer such additional goods or services. The offer of free maintenance is a performance obligation if it were part of the original contract between the OEM and the dealer, whether the offer was explicit in the contract or implied by the OEM s prior business practices. This is a qualitative assessment based on the individual facts and circumstances, and different conclusions could be reached based on different fact patterns. For example, the OEM could conclude that the dealer did not have a reasonable expectation for certain items (such as free maintenance) if they are being offered for the first time, on a limited basis, and with no anticipation of repeating the offer. Accounting for separate performance obligations The objective of identifying and separating performance obligations is to recognise revenue when the performance obligations are satisfied (that is, goods or services are transferred to the customer). An OEM s agreement to transfer a vehicle and to provide free maintenance on the vehicle, for example, would likely require separation. Contracts must be evaluated to ensure that all performance obligations are identified. It is common for an OEM to offer additional incentives (either cash rebates or free goods or services) after the sale of the vehicle to the dealer to assist with the sale to the end user. If the OEM includes a good or service in an arrangement with no change to the total price, the additional good or service may need to be accounted for as a separate performance obligation. The additional good or service could be explicit in the contract or implied based on past experience. If an additional good or service was added to a contract and was not explicitly or implicitly included in the original contract, the additional good or service would be accounted for as an operating expense. New model Current US GAAP Current IFRS An entity should separately account for performance obligations if the good or service is distinct, or if a series of goods or services are homogenous and meet both of the following criteria: Each distinct good or service in the series that the entity promises to transfer consecutively to the customer would be a performance obligation satisfied over time. A single method would be used to Arrangements with multiple deliverables that are not in the scope of construction accounting are divided into separate units of accounting if the deliverables in the arrangement meet specific criteria. Separation is appropriate when the delivered item(s) has value to the customer on a stand-alone basis and the delivery of the undelivered item(s) is probable and substantially within the control of the vendor. For transactions that contain separately identifiable components, it is necessary to apply the revenue recognition criteria to each separately identifiable component of a single transaction in order to reflect the transaction s substance. The customer s perspective is important in determining whether the transaction has a single element or multiple elements. These materials were downloaded from Inform ( under licence.page 126 / 307

127 measure the entity s progress toward satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer. A good or service is distinct if both of the following criteria are met: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. The entity s promise to transfer the good or service is separable from other promises in the contract. Potential impact: The indicators for separation of performance obligations will generally result in similar outcomes as produced by current guidance in IFRS and US GAAP. However, entities in the automotive industry might, in certain cases, need to separately account for more performance obligations under the new standard. This may impact the timing of revenue recognition as compared to current accounting. An entity that concludes, for example, that separate contracts for the construction of a tool and for follow-on production parts should be combined, will likely need to separately account for the obligation to construct the tool and the obligation to produce the parts. The entity will then need to allocate the total transaction price using relative stand-alone selling price for each performance obligation. Warranties that contain service elements will also likely result in more performance obligations under the new standard as compared to today (refer to Product warranties section below). These materials were downloaded from Inform ( under licence.page 127 / 307

128 All promises in a contract to provide goods or services, whether explicit or implicit, are performance obligations if they are distinct. This includes offers to provide goods or services that the customer can resell or provide to its customer. Promises to provide goods or services are different from promises to pay cash to the customer. The latter are not performance obligations and are accounted for as reductions of the transaction price, unless paid for a distinct good or service. Example 5 - Identify the performance obligations (tooling and production contracts) Facts: A supplier enters into two contracts in the same week with an OEM to (1) construct a tool for the OEM (the Tool ) and (2) supply the OEM parts using the Tool. Legal title of the Tool transfers to the OEM prior to production of the parts under the supply contract, and the supplier will recover its cost for the Tool through a separate payment from the OEM equal to the supplier s cost of the Tool. Payment for the Tool is due upon completion of the Tool and its approval by the OEM. Assume that the contract to construct the Tool should be combined with the contract to produce the production parts. Further assume that the supplier is one of several suppliers with the ability to construct the tool and subsequently produce the production parts with existing machinery and equipment. Does the combined contract have separate performance obligations? Discussion: Theanswer depends on whether the Tool is distinct from the production parts manufactured by the supplier. The Tool is distinct in this fact pattern if (1) the customer (i.e., the OEM) can benefit from the Tool either on its own or together with other resources readily available, and (2) the Tool is separable from the production parts. The first condition is met because the Tool and parts are delivered at different times and the OEM can benefit from the Tool by taking it to another supplier and having that other supplier manufacture the production parts. The Tool and subsequent production parts appear to be separable because (1) the development of the Tool is not integrated with the production of parts to produce a combined output, and (2) the Tool is not highly interrelated with the parts because the OEM can purchase or not purchase the parts without affecting the purchase of the Tool. The supplier recognizes revenue for each performance obligation when control of the respective good (the Tool and each individual part) is transferred to the OEM. Example 6 - Identify the distinct performance obligations (free maintenance) Facts: An OEM sells a vehicle to a dealer with "free" vehicle maintenance for the first three years or 30,000 miles of ownership. The maintenance is performed by independent dealers of the OEM and the OEM compensates the dealer a pre-determined amount per event for performing the maintenance. In the same territory, an individual can purchase a similar maintenance service contract from a 3rd party. Would the maintenance service be a separate performance obligation of the OEM? Discussion: Granting a right (such as free maintenance) that the dealer can provide to its customer is likely to be a performance obligation of the OEM. An entity needs to determine whether the vehicle and maintenance services are distinct (that is, can the customer benefit from the vehicle apart from the maintenance) and if the two items separable. The customer can benefit from the vehicle separately from the maintenance since they are sold separately in the marketplace; therefore, the first condition is met. There is no integration of goods or services or customization, nor is the vehicle highly interrelated with the maintenance (the customer could purchase the vehicle without using the free maintenance); therefore, the second condition is also met. The vehicle and maintenance are distinct performance obligations of the OEM. The free maintenance example above could also relate to other "free" items provided with the These materials were downloaded from Inform ( under licence.page 128 / 307

129 vehicle, such as satellite radio trials or roadside assistance. Different conclusions could be reached for each of these items based on the individual facts and circumstances. Determine and allocate the transaction price The transaction price is the consideration the entity expects to be entitled to in exchange for transferring promised goods or services to a customer. The transaction price is readily determinable in most contracts because the customer promises to pay a fixed amount of cash that is due when the entity transfers the promised goods or services (for example, when a supplier sells parts to an OEM for a specified price payable when the parts are delivered). Determining the transaction price in other contracts can be more complex, such as contracts with stated price increases or decreases over time or with volume pricing adjustments. The transaction price allocated to performance obligations in an arrangement is also affected by consideration payable to the customer (or to other parties that purchase the entity s goods or services from the customer) and the time value of money. OEMs and suppliers commonly offer various forms of customer incentives that reduce the transaction price. Two examples of incentives are cash rebates offered by OEMs and volume discounts offered by suppliers. Revenue from both fixed and variable consideration is limited to the amount that is not subject to significant reversal if estimates of the amount of revenue the entity is expected to be entitled to changes. Only revenue that is highly probable under IFRS or probable under US GAAP to be retained is considered to not be subject to significant reversal. Once the amount of consideration is determined, it is allocated to the separate performance obligations in the contract. Entities might have to separately account for more performance obligations than today, so allocating the transaction price might be new to some automotive companies. Final standard Current US GAAP Current IFRS Consideration payable to a customer Amounts paid to a customer (for example, cash rebates) or to other parties that purchase the entity s goods or services are: (a) a reduction of the transaction price; (b) a payment for distinct goods or services that the entity receives from the customer; or (c) a combination of (a) and (b). If consideration paid is a reduction of the transaction price, management reduces the amount of revenue it recognises at the later of when: Cash consideration given by a vendor to a customer is a reduction of revenue earned from the customer, unless the vendor receives an identifiable benefit (goods or services) from the customer and the fair value of such benefit can be reasonably estimated. Sales incentives offered to customers are typically recorded as a reduction of revenue at the later of the date at which the related sale is recorded by the vendor and the date at which the sales incentive is offered. Cash consideration given by a vendor to a customer is a reduction of revenue earned from the customer, unless the vendor is purchasing goods or services from the customer. Sales incentives offered to customers are typically recorded as a reduction of revenue at the later of the date at which the related sale is recorded by the vendor and the date at which the sales incentive is offered. the entity recognises These materials were downloaded from Inform ( under licence.page 129 / 307

130 revenue for the transfer of the related goods or services to the customer; or the entity pays or promises to pay the consideration to the customer (even if payment is conditional on a future event). The promise might be implied by the entity s customary business practice. Allocating the transaction price The transaction price (and any subsequent changes) is allocated to each performance obligation based on relative stand-alone selling price. The stand-alone selling price should be estimated if the actual selling price is not directly observable. Possible estimation methods include cost plus a reasonable margin, market prices for similar goods/services or the residual approach when the selling price is highly variable. An entity must allocate a discount or variable consideration entirely to one (or more) performance obligations if certain conditions are met. There is a hierarchy for determining the stand-alone selling price of a deliverable. This hierarchy requires selling price to be based on vendorspecific objective evidence (VSOE) if available, third-party evidence (TPE) if VSOE is not available, or estimated selling price if neither VSOE nor TPE is available. An entity must make its best estimate of selling price in a manner consistent with that used to determine the price to sell the deliverable on a stand-alone basis. No estimation methods are prescribed; however, examples include the use of cost plus a reasonable margin. The transaction price should be allocated to the separate elements of the arrangement based on relative fair value when elements in a single contract are accounted for separately. The price that is regularly charged when an item is sold separately is the best evidence of the item s fair value. At the same time, under certain circumstances, cost plus a reasonable margin can be used to estimate fair value. The use of the residual method and, under rare circumstances, the reverse residual method might be acceptable to allocate arrangement consideration. Potential impact: These materials were downloaded from Inform ( under licence.page 130 / 307

131 Variable consideration can take several forms. For example, variable consideration might be created by incentives that reduce the transaction price, such as volume discounts. The new standard requires incentives to be accounted for similar to current IFRS. Discounts expected to be taken by the customer over the contract period must be considered in estimating the transaction price using relevant experience. This might result in earlier recognition of discounts as compared to today s US GAAP. Subsequent changes in the estimate of variable consideration are accounted for as a change in the transaction price. An entity can allocate a change in the estimate of variable consideration entirely to one or more distinct goods or services if certain conditions are met. These conditions require that the terms of the variable payment relate specifically to the entity s efforts to satisfy a specific obligation, and that the allocation is consistent with the allocation principle of the new standard. That is, each performance obligation is allocated an amount that depicts the amount of consideration to which the entity expects to be entitled to for satisfying that performance obligation. Little or no consideration allocated to a performance obligation would not meet the allocation objection in most situations. Consideration paid to a customer (for example, cash rebates offered to end consumers by an OEM through its distribution network or below-market financing) is a reduction of the transaction price that reduces revenue. The promise to pay consideration might be explicit in the contract or implied based on an entity s customary business practice. Companies will need to review their current practices to determine if this guidance will affect their accounting for estimating cash rebates. Time value of money could also affect the timing and classification of revenue recognised by OEMs as compared to today. Consider, for example, an extended vehicle warranty that the customer has the option to purchase separately, or a free maintenance program. The consideration for separately purchased warranties and free maintenance programs is typically received at the time of the vehicle sale to the end customer, yet the performance obligation is typically satisfied over a number of years. The entity will need to consider the reasons for requiring the upfront payment to determine if there is a significant financing component in the arrangement. If a significant financing component exists, the transaction price allocated to the warranty or the free maintenance performance obligation should reflect the time value of money as interest income under the new standard. Entities that generate interest income in the ordinary course of business are not precluded from presenting interest income as revenue. The sale price in a tooling arrangement between a supplier and an OEM is often structured either as separate payments at contractually stated amounts (typically equal to the supplier s cost of providing the tooling), or built into the sales price of the follow-on production parts. When tooling and parts contracts are combined, the new standard requires that the transaction price be allocated to the tooling and parts performance obligations based on their relative stand-alone selling prices, although the completion of the performance obligations should continue to be determined separately. In cases where tooling and parts contracts are combined, a portion of the total transaction price will need to be allocated to the tooling contract under the new model regardless of how the tooling arrangement is structured. As many tooling contracts are structured at cost, this will result in the allocation of some margin away from the parts sales to the tooling performance obligation. Example 7 - Variable consideration (volume discount) Facts: A supplier enters into a contract to sell an undefined number of homogeneous components to an OEM. The price for the first 1,000 units is $100 each and $50 each for all units in excess of 1,000. The price for the first 1,000 is not retroactively adjusted once volumes exceed 1,000 units and the supplier believes the OEM will purchase a minimum of 1,000 components. After the initial 1,000 components, the supplier believes there is a 60% probability that the OEM will purchase an additional 200 components, a 30% probability the OEM will purchase an additional 500 units and a 10% probability that the OEM will purchase an additional These materials were downloaded from Inform ( under licence.page 131 / 307

132 700 units. The supplier's assumptions are based on experience with this OEM with similar contracts, its ongoing relationship with the OEM, and its insight regarding the OEM's planned production. The supplier has determined that a probability-weighted estimate is more predictive of the amount it expects to be entitled to receive than an estimate based on the most likely amount. How should the supplier determine the transaction price? Discussion: The supplier should consider the total volume discounts expected to be taken under the contract and the facts and circumstances surrounding a possible change in volume to determine the transaction price. The supplier appears to have a reasonable basis to make such estimates. Therefore, the per-component price is $87.31 (probability-weighted consideration of $117,000/probability-weighted number of parts of 1,340), determined as follows. Probability-weighted consideration C110,000 ((1,000 x C100) + (200 x C50)) x 60% probability C 66,000 C125,000 ((1,000 x C100) + (500 x C50) x 30% probability C 37,500 C135,000 ((1,000 x C100) + (700 x C50) x 10% probability C 13,500 Total probability weighted consideration C 117,000 Probability-weighted number of parts 1,200 components x 60% 720 1,500 components x 30% 450 1,700 components x 10% 170 Total probability-weighted number of parts 1,340 These amounts are subject to the new standard s constraint on variable consideration as the price per unit is variable based on the number of components sold. The supplier appears to have predictive experience with similar performance obligations and therefore believes it is probable there will not be a significant revenue reversal if the estimates of sales volume changes. Any change in the estimate of the number of components purchased is recognised as a change in transaction price in the period of change using a cumulative catch-up approach (changes in variable consideration are accounted for as a change in transaction price). Based on the facts presented, it would be appropriate to include the variable consideration in the total transaction price. Example 8 - Allocating the transaction price (additional cash incentive) Facts: An OEM sells a vehicle with three years of maintenance to a dealer for $40,000. The standalone selling price of the vehicle and the maintenance services is $40,000 and $2,000, respectively. Therefore, there is a $2,000 discount inherent in the transaction price. After the OEM s sale of the vehicle to the dealer, but prior to the dealer s sale to the retail customer, the OEM adds an additional cash incentive of $500 which was not contemplated when the vehicle was sold to the dealer. This would result in a reduction to the transaction price of $500 (from $40,000 to $39,500). How should the OEM account for the added incentive specifically, should it be allocated to both the satisfied and unsatisfied performance obligations or to just the remaining unsatisfied performance obligation? Discussion: Rebates are variable consideration and accounted for as an adjustment to the transaction price. A change in transaction price that does not involve a contract modification is normally allocated to each performance obligation in the contract on the same basis as at contract inception. This includes satisfied and unsatisfied performance obligations. The These materials were downloaded from Inform ( under licence.page 132 / 307

133 transaction price is decreased to $39,500 and, using the relative standalone selling prices of the two performance obligations, the $500 rebate is allocated to the vehicle and maintenance services in the amounts of $476 ($500 x (40,000/42,000)) and $24 ($500 x (2,000/42,000)), respectively. The amount allocated to a satisfied performance obligation (in this case, the vehicle) is recognized as a reduction of revenue in the period in which the change in transaction price occurs. Since there are normally no specific terms between the OEM and the dealer related to the rebate offers (as they relate to the sale of the vehicle to the dealer), it would be difficult to conclude that the entire additional rebate could be allocated to only the vehicle sale (as opposed to being allocated between the vehicle and the maintenance services based on relative selling price). Recognise revenue when performance obligations are satisfied Revenue recognition under current guidance is based primarily on the transfer of risks and rewards. Under the new standard, revenue is recognised upon the satisfaction of an entity s performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. The change to a controlbased standard will require careful assessment of when an entity should recognise revenue. The timing of when revenue is recognised might be consistent with current practice for many automotive contracts related to the sale of production goods. This should, however, not be assumed for all contracts, in particular for tooling contracts, engineering, research and development contracts and contracts to build prototypes. Contracts between suppliers and OEMs for the sale of tooling and prototypes (where ownership transfers from the supplier to the OEM) are common and can take several different forms. The supplier may receive a lump-sum payment from the OEM in some arrangements, while in others the supplier may be reimbursed periodically as certain milestones are met. Suppliers will have to assess the terms of the contract to determine if control transfers at a point in time or over time. If control transfers at a point in time, the new standard provided some indicators to determine when control has transferred. Those indicators include 1) the seller has a right to payment, 2) the customer has legal title, 3) the customer has physical possession, 4) the customer has significant risks and rewards of ownership, and 5) the customer has accepted the asset. No one factor is determinative on a stand-alone basis. Potential impact: The new guidance will require an entity to determine when control of the good or service has transferred to the customer. The timing of revenue recognition could change when evaluated based on a transfer of control rather than transfer of risks and rewards of ownership. Overall this could result in earlier recognition if contracts are determined to transfer control over time. The effect of combining contracts and allocating transaction prices based on the separate performance obligations could also result in earlier revenue recognition. For example, tooling arrangements often are priced with the intent to be margin-neutral (that is, the supplier will be reimbursed for actual cost). If the tooling and parts contracts are combined, and each is considered a separate performance obligation, then a portion of the margin from the parts supply arrangement would likely be allocated to the tooling as part of the relative stand-alone selling price allocation. Example 9 - Recognise revenue (for an obligation that is satisfied over time) Facts: A supplier enters into a contract with an OEM to (1) construct a Tool for the OEM, and (2) supply the OEM with parts using the Tool. The Tool and the supply arrangements are separate performance obligations and the supplier would incur significant economic losses if it were to attempt to re-work the Tool for another OEM if the OEM terminates the contract (i.e., there is no alternative use for the Tool). The OEM is contractually obligated to reimburse the supplier for its These materials were downloaded from Inform ( under licence.page 133 / 307

134 costs to date including a reasonable profit margin to construct the Tool if the OEM cancels the contract other than for breach. Accordingly, the Tool would qualify as a performance obligation satisfied over time. How should revenue related to the Tool be recognized? Discussion:In this example, the Tool performance obligation is satisfied over time because the supplier s performance does not create an asset with an alternative use and the supplier has the enforceable right to payment which should include a recovery of the costs incurred by the entity plus a reasonable profit margin. In other arrangements, the enforceable right to payment may only include recovery of the costs incurred by the entity and therefore an entity may not meet this criterion. In that case, an entity would need to evaluate whether the entity s performance creates or enhances an asset and if the customer controls the asset as it is created to determine if the performance obligation is satisfied over time. The supplier will need to select the most appropriate recognition method (either an input or output method) to measure its performance over the contract term if revenue is recognized over time. An output method, such as units produced, may be appropriate if the entity includes in its revenue measure the work-in-progress and completed-but-not-delivered items that are controlled by the customer. The supplier might conclude an input method is more appropriate if there is a direct relationship between the entity s inputs and the transfer of control of goods or services to the customer. Example 10 - Recognise revenue (for an obligation where control transfers at completion) Facts:Assume the same facts as in Example 9, except: The OEM can cancel the contract at any time without a termination or makewhole payment because the Tool can be readily used to produce parts for other OEMs; and Title (assumption of control) of the Tool passes to the OEM only upon its completion and acceptance by the OEM. How should the supplier recognize revenue? Discussion: In this example, the Tool has an alternative use by the supplier, and control of the Tool is not transferred to the OEM during the work-in-process phase. The supplier also does not have the right to payment for performance completed to date (including a reasonable profit margin) in the event of a contract termination by the OEM. Revenue should be recorded when the tool is completed and control is transferred. Other considerations Product warranties Product warranties are common in the automotive industry. Both OEMs and suppliers routinely provide product warranties to their customers. Suppliers generally provide a standard warranty to all customers that the product complies with agreed-upon specifications for a specified period. OEMs generally provide a standard warranty on vehicles for a certain number of years or a specified mileage. OEMs might also provide an extended warranty or certain services (for example, maintenance or roadside assistance) in addition to the standard warranty coverage. The new standard draws a distinction between product warranties that the customer has the option to purchase separately and those that cannot be purchased separately. Companies will need to exercise judgment when assessing warranties which are not sold separately to determine if there is a service component inherent in the warranty that needs to be accounted for as a separate performance obligation. These materials were downloaded from Inform ( under licence.page 134 / 307

135 New model Current US GAAP Current IFRS Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Entities typically account for warranties that cover latent defects in accordance with existing loss contingency guidance. An entity recognises revenue and concurrently accrues any expected warranty cost when the product is sold. The warranty should be accounted for as a cost accrual if it promises that the product complies with the specifications in the contract and the customer does not have the option to purchase a warranty from the entity separately. An entity might provide a warranty that calls for a service to be provided to the customer (for example, maintenance) in addition to a promise that the product complies with agreed-upon specifications. If the entity cannot reasonably separate the two obligations, they should account for both together as one performance obligation. Revenue from separately priced extended warranty contracts is deferred and recognised over the expected life of the contract. Revenue is typically recognised at the time of sale for products that are sold with a standard warranty, and a corresponding provision is recognised for the expected warranty cost. A product sold with an extended warranty is treated as a multiple element arrangement. Revenue from the sale of the extended warranty is deferred and recognised over the period covered by the warranty. No costs are accrued at the inception of the extended warranty agreement. The new guidance is similar to current accounting for warranties in many cases. There might, however, be situations where the accounting for warranties could result in revenue deferral for example, when the entity s warranty provides a service to the customer in addition to a promise that the product complies with the specifications in the contract. Entities will need to determine which, if any, part of their product warranty contains a service component and should account for the service component as a separate performance obligation, deferring revenue relating to that service and recognising it as the service is provided. Entities that offer separately priced warranties might also be affected, as the arrangement consideration will be allocated on a relative stand-alone selling price basis rather than at the extended warranty contract price if the contracts for the vehicle and the separately priced warranty are combined. Contract costs Entities in the automotive industry may incur costs to design and develop products and tooling or to build tooling that is not sold to the OEM (that is, the supplier retains ownership and the tooling is not a performance obligation). Suppliers might incur costs to develop tooling, for example, in anticipation of a long-term supply arrangement. A contract might exist prior to the These materials were downloaded from Inform ( under licence.page 135 / 307

136 costs to develop the tooling being incurred. In other instances, a contract might not be agreed to until after costs have been incurred. These costs may be either expensed as incurred, or capitalized and amortized to expense as the related revenue is recognized under current U.S. GAAP and IFRS. This current accounting treatment depends on a number of considerations, including the nature of the costs and the tooling being developed, whether the supplier has a non-cancellable right to use the tooling, and whether the supplier will be reimbursed for the costs incurred. The new standard includes guidance on both costs to obtain and costs to fulfill a contract, and may change current practice. Under the new standard, incremental costs of obtaining a contract should be recognized as an asset so long as the costs are expected to be recovered. As a practical expedient, such costs may be expensed as incurred if the amortization period is one year or less. Capitalized costs are amortized as control of the related goods or services transfers to the customer. Direct costs of fulfilling a contract will generally be expensed as incurred under the new standard (if not within the scope of other standards), unless they generate or enhance a resource to be used to satisfy future performance obligations, and are expected to be recovered. Costs associated with pre-production activities, such as those associated with long-term supply arrangements, might be capitalized more often under the new standard than under both current U.S. GAAP and current IFRS. Financing arrangements Many OEMs have finance arms that serve as a potential finance source for customers that lease or buy vehicles from dealers. When a dealer and an end customer enter into an arrangement for the end customer to lease a vehicle, the dealer will often either sell the vehicle and the related lease to the OEM s financing division (that leases the vehicle to the end customer), or to a thirdparty finance company. When vehicles sold to dealers are repurchased by an OEM's financing division, the OEM must meet certain conditions, particularly under current U.S. GAAP, in order to recognize revenue on the initial sale of the vehicle when the vehicle is delivered to the dealer. A different set of conditions must be met for the OEM to recognize revenue on the initial sale to the dealer if the vehicle and lease are sold to a third-party finance company. These specific conditions are not included in IFRS; rather, revenue is generally recognized from sales to dealers or distributors when the risks and rewards of ownership have passed. OEMs generally meet the current criteria to recognize revenue at the time of sale to the dealer. For transactions involving the OEM s finance affiliate, a significant change in the timing of revenue recognition is not expected as a result of the change in the guidance. This is because the new standard requires revenue to be recognized when control is transferred and it is likely that control has transferred if the transaction met the specific criteria under existing guidance. The new guidance may result in earlier revenue recognition for OEMs that did not meet the current U.S. GAAP criteria for revenue recognition in instances where the dealer's sales are to third-party finance companies and the sales are coupled with other agreements, such as residual value guarantees. Significant changes in the timing of revenue recognition under IFRS are not expected in either scenario. Repurchase options and residual value guarantees OEMs sell vehicles to certain customers under contracts (for example, daily rental car companies) that often provide the customer with a put option or residual value guarantee. These options generally provide a guaranteed residual value to the customer when the customer sells the vehicle. Two common scenarios include: (a) the OEM agrees to reacquire the vehicle at a guaranteed price, or (b) the OEM reimburses customers for any discrepancy between the sales proceeds received for the vehicle and the guaranteed minimum resale value. There is currently specific U.S. GAAP that requires these contracts to be accounted for as leases. IFRS does not contain specific guidance on how to account for such arrangements. These materials were downloaded from Inform ( under licence.page 136 / 307

137 Under the new guidance, contracts containing repurchase options will be accounted for as a lease when the customer has the right to require the OEM to repurchase the vehicle and the customer has a significant economic incentive to exercise that right. To determine whether a customer has a significant economic incentive to exercise its right, an entity should consider various factors, such as the relationship of the repurchase price to the expected market value of the vehicle at the date of repurchase and the amount of time until the right expires. The customer has an economic incentive to exercise the put option if the repurchase price is expected to significantly exceed the market value of the vehicle at the time of repurchase. Contracts may require the OEM to reimburse the customer for any deficit between the customer s sales proceeds received for the vehicle and a guaranteed minimum resale value. An entity should consider the guidance in the relevant financial instruments standard to determine the amount of the liability to be established for the residual value guarantee, with a corresponding reduction to the transaction price. Right of return Return rights in the automotive industry are common and come in a variety of forms. Revenue is not recognised for goods expected to be returned and a liability should be recognised for the expected amount of refunds to customers. An asset and corresponding adjustment to cost of sales should be recognised for the right to recover goods from customers upon settling the refund liability. This asset will initially be measured at the cost of the inventory sold, less any cost to recover. The asset will also need to be assessed for impairment each reporting period. The effect of product returns under the new standard will be largely unchanged from current guidance under IFRS and US GAAP. The primary difference is that the balance sheet will reflect the refund obligation and the asset for the right to goods to be returned on a gross basis. Companies will use a probability-weighted or most likely outcome approach, whichever is most predictive, to determine the likelihood of a sales return under the new standard. About PwC s Automotive practice Our Automotive practice leverages its extensive experience in the industry to help companies solve complex business challenges with efficiency and quality. One of our practice s key competitive advantages is Autofacts, a team of automotive industry specialists dedicated to ongoing analysis of sector trends. Autofacts provides our team of more than 4,600 automotive professionals and our clients with data and analysis to assess implications, make recommendations, and support decisions to compete in the global marketplace. Questions? PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in Accounting Consulting Services. Entertainment and media industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in These materials were downloaded from Inform ( under licence.page 137 / 307

138 required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth INT is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for entertainment and media entities as they transition to the new standard. Overview The entertainment and media sector comprises a diverse set of sub-sectors, including filmed entertainment, television, music, video games, publishing, radio, and internet. This supplement explores the effect of the new revenue standard on these businesses, and contrasts it with current practice under IFRS and US GAAP. This supplement provides an initial analysis of key questions and issues facing the industry which will continue to evolve as entities address the challenges of implementation. The examples and related discussions herein are intended to highlight areas of focus to assist entities in evaluating the implications of the new standard. The new revenue standard is principles-based, requiring the application of significant judgement. Scope The standard applies to all contracts with customers, excluding leases, financial instruments, certain guarantees and arrangements in the scope of other guidance. A customer is defined as a party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities. Entities in the entertainment and media sector will need to evaluate their collaborative arrangements to determine if those arrangements are contracts with customers and thus in the scope of this standard. A contract outside the scope of the standard is one in which a collaborator or partner shares in the risk of developing a product rather than obtaining an output of the entity s ordinary activities. For example, a film studio may enter into an arrangement with a counterparty (such as another production company) to co-develop a film for international distribution. Such an arrangement is not in the scope of the revenue standard if the parties share the risk of developing the film. Alternatively, it will likely be in scope if the substance of the arrangement is that the studio is selling its film to the counterparty or providing production services. Licences Licences in the entertainment and media sector take a variety of forms, such as rights to a syndicated television show, a licence to a music catalogue, or a licence to utilise an animated character s image. Throughout the deliberations of the standard, there were many viewpoints and models discussed. The standard includes a model that recognises revenue from certain licences upfront and others over time. Right to use versus right to access New standard Current US GAAP Current IFRS The standard emphasises the Industry-specific guidance IFRS does not contain any need to consider whether a exists with respect to certain industryspecific accounting for licence is distinct from any forms of IP licences. entertainment and media other performance obligations entities. In general, revenue in an arrangement. A licence For film licences (including should not be recognised under is distinct if a customer can episodic television series in licensing arrangements until benefit from it on its own or syndication) revenue is performance under the contract These materials were downloaded from Inform ( under licence.page 138 / 307

139 together with other resources that are readily available, and the licence is separable from other obligations. If it is not distinct, revenue is recorded based upon the transfer of the combined performance obligation. Licences are either a promise to provide a right to the entity s intellectual property (IP) at a point in time, or a promise to provide access to an entity s IP as it exists at any point during the licence period. Licences that provide access to an entity s IP over time have all of the following characteristics: 1) The licensor will undertake activities that significantly affect IP to which the customer has rights. 2) The licensee is directly exposed to the effects (whether positive or negative) of the licensor s activities. 3) The licensor s activities do not transfer a good or a service to the customer as they occur. If any of the criteria above are not met, the licence is a right which transfers at a point in time, starting when the customer can direct the use of and obtain the benefits from the licence. Restrictions on the time period, geography or use of the IP do not affect the determination of whether or not the licence provides a right or provides access to IP. Guarantees of a valid copyright to IP should similarly not be considered in making the determination. recorded when: there is persuasive evidence of an arrangement; the film is complete or available for delivery; the licence period has begun; the fee is fixed or determinable; and collection is reasonably assured. For music licences, revenue may be considered an outright sale when: there is a noncancellable contract; a fixed fee; the music right and recording have been delivered; and there are no remaining significant obligations to furnish additional music. If these criteria are not met, revenue should be recognised over the remaining performance or licence period. For software licences (such as video games), there is a significant set of rules that require not only standard revenue recognition criteria to be achieved (for example, persuasive evidence of an arrangement) but also require vendor-specific objective evidence in order to separate any software deliverables, such as postcontract customer support (PCS). For other forms of licensing, there is no industry-specific guidance, so general revenue recognition rules would apply. Entities must determine whether a sale (upfront) or a lease (over time) model is more appropriate. has occurred and the revenue has been earned. The assignment of rights for a nonrefundable amount under a noncancellable contract permits the licensee to use those rights freely. The transaction is in substance a sale when the licence has no remaining obligations to perform. A fixed licence term is an indicator that the revenue should be recognised over the period because the fixed term suggests that the licence s risks and rewards have not been transferred to the customer. However, the following indicators should be considered in determining whether a licence fee should be recognised over the term or upfront: fixed or non-refundable guarantee; contract is noncancellable; customer is able to exploit the rights freely; and vendor has no remaining performance obligations. These materials were downloaded from Inform ( under licence.page 139 / 307

140 Potential impact: The accounting for licences under the new standard could significantly affect many entertainment and media entities due to the elimination of industry-specific revenue guidance. The standard establishes new criteria to determine the pattern of revenue recognition. Certain types of licence may be accelerated while others could be deferred when compared to current treatment. An entity must first establish whether a licence is distinct from other goods and services in the arrangement before determining the pattern of revenue recognition for the licence. This identification of distinct licences may be challenging, especially when multiple licences are included in an arrangement or when a licence is offered with a service (see the Multiple performance obligation section). For many entertainment and media entities, the most challenging aspect of accounting for licences will be the assessment of whether a licence is transferring a right to use intellectual property at a point in time or is providing access to intellectual property over time. An entity needs to consider whether a customer can direct the use of, and obtain substantially all of the remaining benefits from, the licence when it is transferred. A customer cannot obtain control if the intellectual property to which the customer has rights changes over the licence period. Effectively, the customer will be simultaneously receiving and benefiting from the ongoing transfer of such rights. Determining whether a licence meets the relevant right to access criteria may be straightforward in instances in which an entity is clearly not performing activities that affect the intellectual property as well as in instances in which the intellectual property is continually changing. The new standard provides examples of entertainment and media licences which fall into these two categories. An example within the new standard describes the licence of a music recording to a retailer. The underlying intellectual property is decades old and it is asserted that no further activities were being performed. The conclusion of the example is that the licence is transferred at a point in time (upfront). Another example in the standard describes the licence of a sports logo to an apparel manufacturer for a fixed-fee plus a sales royalty. In this example, the underlying intellectual property is continually changing based upon the team s activities of fielding a competitive team. Further, the team has a shared economic interest with the manufacturer through a sales-based royalty. The conclusion of the example is that the licence transfers over time. Many entertainment and media licences, including licences of music, film and television properties, will involve less clear fact patterns than these two examples. Entities will need to apply judgement to determine how their activities affect the intellectual property to which the customer has rights. The manner in which entertainment and media entities monetise intellectual property could contribute to the challenge of these judgements. Many entities license content to multiple distribution platforms, such as cable outlets, broadcasters, and online distributors. The performance of the content within each window of exploitation can affect its value to the licensor and the licensee. Therefore, there are incentives for licensors to continue to support their intellectual property throughout its useful life, through developing complementary content or through promotional activities targeted at end consumers or other licensees. The level of such activities may vary significantly depending upon the nature of the intellectual property, its age, and the business model of the licensor. The revenue standard does not include any additional guidance on either the type or extent of activities that would be considered sufficient to significantly affect the intellectual property during the licence period and therefore affect the pattern of revenue recognition. While not determinative, a shared economic interest could create an incentive for the licensor to undertake additional activities. Entities will need to develop a These materials were downloaded from Inform ( under licence.page 140 / 307

141 methodology to identify and then analyse their relevant activities in relation to the rights granted to licensees, including whether the customer is exposed to the effects of the activities and whether they result in additional distinct goods or services being transferred. It might be difficult for some entities that grant a significant number of licences to perform a robust analysis on a licence-by-licence basis. To the extent licences within a certain category or type are structured similarly with similar activities undertaken by the licensor, it may be appropriate to consider such licences together as a portfolio as long as results would not differ materially from a licence-by-licence assessment. As stated above, the following are not considered when determining whether a licence represents access over time or a right transferred at a point in time: Restrictions, such as for time, geography or use, as such restrictions are merely aspects of the rights that are transferred. Guarantees of a valid copyright to intellectual property. Many industry licences include restrictions on time, geography or use. For example, a studio may license rights that permit a cable channel to exhibit a film up to five times over the next two years. These restrictions do not affect whether the licence transfers at a point in time or over time, but are aspects of the right transferred. Entities will need to take care to identify distinct performance obligations before applying this concept. For example, if the studio licensed five separate films to be exhibited over the same two-year period, the transfer of the rights to each film would likely be separate performance obligations. An entity would need to evaluate each performance obligation separately to assess the timing of recognition. Licence revenue should not be recognised until the licensee can benefit from the rights that have been transferred, whether at a point in time or over time. For both licences recognised at a point in time and those recognised over time, sales- or usagebased royalties related to licences of intellectual property cannot be recognised before the underlying sales or usages occur (see the Variable consideration section). Current US GAAP provides entertainment and media industry-specific guidance for licence transactions not only with respect to the timing of recognition but also with respect to various other concepts such as the treatment of crosscollateralised film deals, music licences for new and library content, contingent royalties, the fair value of softwarerelated deliverables and film licence modifications. The new standard has no industry-specific guidance, and furthermore, the guidance on licences only addresses the timing of recognition and treatment of sales-based royalties as discussed above. An entity will generally need to apply the other steps of the standard (identifying the contract, identifying distinct performance obligations, determining the transaction price, and allocating the price to distinct obligations) to determine the appropriate accounting for its licence arrangements just as it would for non-licences. Multiple performance obligations The new revenue standard requires entities to identify all of the promises in a contract and to determine whether those obligations are distinct. A performance obligation is a promise to transfer goods or perform services that are distinct from other promises in the contract. The criteria for separating performance obligations are similar to existing standards, but there are several differences. New standard Current US GAAP Current IFRS Identification of performance obligations The model requires promises An entity should identify all deliverables in an arrangement and then make a determination of the These materials were downloaded from Inform ( under licence.page 141 / 307 An entity should apply the revenue recognition criteria to each separately identifiable component of a single

142 that are distinct to be accounted for separately (assuming they are satisfied at different times). A good or service is distinct and should be accounted for separately if the customer can benefit from the good or service either on its own or together with other resources readily available to the customer and if the entity s promise to transfer the good or service to the customer is separable from other promises in the contract. appropriate unit of account based upon the deliverables that have standalone value. transaction if necessary to reflect the transaction s substance. The customer s perspective is important in determining whether the transaction should be accounted for as one element or multiple elements. The arrangement might be accounted for as one transaction if the customer views the purchase as one element. Allocation of transaction price The transaction price should be allocated to each performance obligation based on relative standalone selling prices. If a stand-alone selling price is not available, management should make an estimate of it maximising the use of observable inputs. Arrangement consideration is allocated to separate units of account based upon relative selling price. For software transactions, relative selling price can only be determined by vendorspecific objective evidence (VSOE). For non-software transactions, objective evidence must be used if available. Otherwise, the entity s best estimate of selling price is used. At any point in time, amounts recognised in a multipleelement transaction are limited to that which is not contingent on future deliverables. When elements in a single contract are accounted for separately, fair value should be used in allocating the transaction price to the separate elements. Potential impact: Identifying distinct obligations Entities might identify different performance obligations under the new standard than under current guidance, and they may need to allocate the transaction price to those performance obligations differently than they do today. The following are common bundled arrangements that will require assessment to determine if there is more than one performance obligation: Distribution agreements that provide customers with different services over the subscription period. Marketing deals that deliver advertising to customers across several platforms and time periods. Licensing arrangements that provide access to library content as well as future output. These materials were downloaded from Inform ( under licence.page 142 / 307

143 The licence of a music download to a consumer along with an obligation to continue to host the content remotely to allow for future downloads. In each of these situations, an entity will first need to determine if a customer can benefit from a good or service on its own or together with resources readily available to it. The entity will then need to determine if the good or service is separable from other promises in the contract, meaning it is distinct within the context of the contract. This determination will require judgement, as the entity must also determine whether it meets any of the following criteria to determine if a promise can be separated from other promises in the contract: Whether the entity is providing a significant service of integrating the goods or services with other goods or services in the contract into a bundle of goods or services that represents the output the customer has contracted to receive. Whether the good or service significantly customises or modifies another good or service in the contract. Whether the good or service is highly dependent on, or highly interrelated with, other goods and services in the contract. Within the entertainment and media industry, these judgements may become more challenging with the growth of digital business models and the proliferation of on-demand streaming services and other emerging platforms. Allocating transaction price Allocating the transaction price across all of the obligations in an arrangement could differ from current practice in certain circumstances. The revenue standard eliminates the requirement under current US GAAP to defer revenue that is contingent on future deliverables (sometimes referred to as the contingent revenue cap ). This change means that entities need to allocate revenue to free or discounted products or services that are provided in a contract, even if payment for those goods or services is contingent on transferring other goods or services promised in the contract. Consider an advertising contract that provides free spots or other services at the inception of a contract with subsequent spots billed at a higher rate. Under current US GAAP, no amounts are allocated to the free front-end services, even if these spots have stand-alone value, since all consideration is contingent on providing the spots in the future. Under the new standard, the transaction price for the entire arrangement will be allocated to each of the spots based upon relative stand-alone selling price. The stand-alone selling price of a good or service must be estimated if it is not sold on a standalone basis. The new standard allows for several alternatives that can be used to form estimates of relative selling price. This flexibility is most clear in relation to software transactions (including video games). An entity will no longer be required to demonstrate vendor-specific objective evidence (VSOE) of fair value in bundled software arrangements in order to separately account for licences as is currently required under US GAAP, aligning the guidance more closely with IFRS. Example - Online functionality included with a video game Facts: VideoCo develops and sells video games for C50. The video game can be played on its own, but VideoCo includes additional services that enhance the user experience by hosting multi-player game formats and other online services for no additional cost to the customer. The additional services are not sold on a stand-alone basis by VideoCo. How many performance obligations should VideoCo identify in this arrangement? Discussion: The user can play the game in single-player mode without regard to the multi-player functionality. Therefore, the customer can benefit from each item on its own. These materials were downloaded from Inform ( under licence.page 143 / 307

144 VideoCo next assesses whether the game and the online functionality are distinct within the context of the contract. This determination requires more judgement. VideoCo will need to assess the extent to which it is performing a service of integrating the game with the online services and the dependency of the game on such services to determine whether the game is distinct from the online services. If VideoCo concludes that the game and the services are separable, it will allocate the C50 transaction price to each performance obligation based on their estimated relative stand-alone selling prices (VSOE would not be needed). VideoCo would recognise revenue as each of the performance obligations is satisfied. If the obligations are not separable, the transaction price is recognised over the combined service period. Upfront fees for activation services Cable television entities often charge customers an activation or installation fee at the inception of a monthly subscription service. Cable television entities follow specific accounting guidance under current US GAAP that allows upfront installation fees to be recognised as revenue to the extent of direct selling costs (which differs from IFRS). The new standard removes this industryspecific guidance. All entities (including cable television entities) will need to determine if a distinct good or service is transferred to the customer at the inception of the arrangement to determine if revenue should be recorded at that time, similar to IFRS today. Options to acquire additional goods or services An entity may grant a customer an option to acquire additional goods or services in conjunction with a current transaction. Such options may provide a discount on subsequent purchases or the ability to extend or renew the agreement. Licensors will need to determine if the option gives the customer a material right to determine the appropriate accounting. New model Current US GAAP Current IFRS An option to acquire additional goods or services gives rise to a separate performance obligation if the option provides a material right to the customer that the customer would not receive without entering into that contract. Management will need to estimate the transaction price to be allocated to the option based on its estimated standalone selling price as, in Guidance exists within software accounting standards that a discount offered on future purchases must be assessed to determine if it is significant and incremental to discounts that are normally offered to customers. If there is a significant and incremental discount, it represents a deliverable under the arrangement. effect, the customer is paying For non-software transactions, for future goods or services to predominant practice is to be received. Revenue is follow the software model by recognised for the option analogy (except that VSOE of when it expires or when the fair value is not required). future goods or services are transferred to the customer. An option to acquire additional goods or services at a price within a range of prices typically charged for those goods or services is not a material right even if the If an entity grants its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, it accounts for that option as a separate component of the arrangement and allocates consideration between the initial good or service provided and the option. Entities often analogise to the accounting for customer loyalty programs and defer revenue related to significant options and recognise it only upon redemption. These materials were downloaded from Inform ( under licence.page 144 / 307

145 option can only be exercised because of entering into the previous contract. Such an option is considered a marketing offer. Potential impact: Many options to renew or extend agreements in the entertainment and media sector are at constant or escalating prices, mitigating the potential that an option represents a material right. However, to the extent an option includes discounted offers or appears to be a material bargained-for future discount to the customer, an entity will need to consider whether the option is a distinct performance obligation in the arrangement. Examples of potential options to consider in the entertainment and media sector include: Option to renew a television series A studio may develop an episodic television series for a network with an agreement to license the first season for a set price in addition to granting the network a fixed-price option to renew the series for an additional two seasons. The studio will need to assess whether granting a fixed-price option provides a material right to the network, since a returning show may have a higher value in subsequent seasons than in the initial season. Option to extend a subscription agreement A publisher of periodicals may offer a customer a subscription for a 12-month period with an option to extend the subscription at any point for a lower issue price. The publisher will need to assess whether the option represents a material right that is a separate performance obligation or a marketing offer within the normal range of prices charged to subscribers. Option to purchase additional advertising A broadcaster may reach an agreement to sell to an advertiser 100 advertising spots at various points over the next year at a fixed price, along with an offer for an additional 50 advertising spots at the same per-spot price at the advertiser s sole option. This option could provide a material right to the advertiser since it protects them from increases in advertising rates during the year (that is, scatter market pricing). However, it will not provide a material right if the price charged is in the range of rates currently being offered in the same time period. Variable consideration The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. The transaction price might include an element of consideration that is variable or contingent upon the outcome of future events, including (but not limited to) discounts, rebates, refunds, credits, incentives, performance bonuses and royalties. Variable consideration is common in many forms in the entertainment and media sector. Examples include sales- or usage-based royalties, price protection offered on home entertainment DVD sales, cumulative volume discounts offered to significant advertisers, and performance bonuses on marketing contracts. New standard Current US GAAP Current IFRS Variable consideration should Revenue is only recognised Revenue is recognised when it be estimated and included in when it is fixed or is probable that economic the transaction price to the determinable and when benefits will flow to the entity These materials were downloaded from Inform ( under licence.page 145 / 307

146 extent that it is highly probable (IFRS) or probable (US GAAP) that a significant subsequent reversal in the cumulative amount of revenue recognised will not occur if estimates of variable consideration change. An exception is provided for revenue recognised from sales- or usage-based royalties on licences of intellectual property. Royalties from licences of IP are not included in the transaction price until the subsequent sale or usage occurs, and the related performance obligation has been satisfied (or partially satisfied). collection is reasonably assured. Royalty revenue is generally recorded in the same period as the sales that generate the royalty payment. and the amount of revenue can be measured reliably. Revenue from royalties accrues in accordance with the terms of the relevant agreement and is usually recognised on that basis unless it is more appropriate to recognise revenue on some other systematic basis. Revenue is recognised for a licence fee contingent on the occurrence of a future event only when the revenue is reliably measurable and it is probable that the fee will be received, which may be when the event has occurred. Revenue is recognised when the licence is available for exploitation if the licence fee or royalty is probable of being received and is reliably measurable. Potential impact: Sales- or usage-based royalties on licences of IP The IASB and FASB decided on an exception relating to variable consideration for sales- or usage-based royalties of licensed intellectual property. Such royalties from licences of intellectual property are not included in the transaction price until the underlying contingency is resolved. This exception means that the treatment of many contingent royalty transactions will remain consistent with current practice under both IFRS and US GAAP. An entity will need to consider whether an arrangement includes a sales- or usage-based royalty on licences of intellectual property in order to apply the exception. A sale of intellectual property does not qualify for the exception. The exception also does not apply if intellectual property is bundled with a tangible good (such as a physical book) and is not distinct from the tangible good. Other forms of variable consideration Variable consideration is common in the entertainment and media sector beyond just sales- or usage-based royalties. An entity estimates variable consideration based upon either the expected value (the sum of probability-weighted amounts) or the most likely value (the single most likely result). An entity must use the method that best predicts the variable consideration in the circumstances. Factors to consider when determining whether it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of revenue will not occur include the length of time of any underlying uncertainty, the experience of the entity with similar transactions, and the range of These materials were downloaded from Inform ( under licence.page 146 / 307

147 possible consideration amounts. An entity that is currently deferring revenue from certain transactions pending the resolution of a price contingency may be able to recognise revenue earlier under the new standard if there is a minimum amount that can be estimated that is probable of not having a significant revenue reversal in the future. An advertising agency that earns performance bonuses on marketing contracts will be required to estimate the bonuses to be achieved when recognising revenue as marketing service performance obligations are fulfilled. In situations where an entity receives either all of the bonus or none of it, an entity might conclude that the most likely value is the better method since the bonus is either received in full or not at all. An agency that earns a fee that varies over a range of customer advertising outcomes may, however, determine that an expected value approach provides a better estimate of the transaction price. In all cases, the agency would need to consider the constraint and whether it was probable or highly probable that a significant reversal of revenue would not occur. Similar analysis would be required for other forms of industry variable consideration including adjustments to advertising contracts for audience shortfalls, adjustments to cable carriage rates upon triggering a most-favourednation clause, and price protection that is offered on home entertainment DVD sales. Return rights Return rights are common in sales transactions that include physical goods sold to retailers. Some of these rights may be articulated in contracts with customers or distributors, while some are implied during the sales process or based on customary business practice. Return rights are commonly granted by book publishers and print media as well as film and music producers with respect to DVDs and CDs. New standard Current US GAAP Current IFRS Revenue should not be recognised for goods Revenue from sales transactions with a right of Revenue is typically recognised at the gross amount (in full) expected to be returned; return should be recognised at with a provision recorded rather, a liability should be recognised for the expected amount of refunds to customers. The refund liability should be updated each the time of sale if several conditions are met (for example, price is fixed or determinable, or buyer is obligated to pay) and a against revenue for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an reporting period for changes in reasonable estimate of returns established historical record expected refunds. An asset of can be established, typically and other relevant evidence. sales should be recognised for only possible with a large the right to recover goods from volume of relatively customers on settling the homogeneous transactions. refund liability, with the asset initially measured at the original cost of the goods. Returns reserves should be determined using the guidance for variable consideration, including the constraint that revenue should only be recognised for the amount that is probable of not resulting in a significant cumulative revenue reversal if estimates change. These materials were downloaded from Inform ( under licence.page 147 / 307

148 Potential impact: Accounting for returns under the new standard is similar to current practice, but differences exist that entities will need to consider. The balance sheet will need to reflect the entire refund obligation as a liability and will include an asset for the right to the returned goods. When a significant portion of returns is expected (for example, some newsstand sales), this change in presentation could result in a significant grossup of the balance sheet as compared to current practice. Estimates of sales returns may also be different than under current practice. For instance, under current US GAAP, if a publisher is not able to form reasonable and reliable estimates of returns, all revenue is deferred until better estimates of returns can be made. This may not be until the retailer reports that it has sold the goods to the end customer. The new standard requires that an estimate of returns be made to the extent that the cumulative amount of revenue recognised is not probable of a significant reversal. This could result in the recording of a minimum amount of revenue upon sale to the retailer even when an estimate of total revenue is not reliable. Example - Sale of physical product by a publisher Facts: A publisher sells 100 copies of Book A for C10 each. The books cost C2 to produce and include a return right. The retailer takes physical possession of the books and is contractually obligated to pay for the inventory once the books are received. The estimated sales returns associated with this transaction are 30% based on historical return patterns. The publisher estimates that the costs of recovering the products will be insignificant and expects the returned products can be resold at a profit. How should the publisher account for the sale of Book A? Discussion: Once control transfers to the retailer, C700 of revenue (C10 x 70 products (100 less the 30% expected returns)) and cost of sales of C140 (C2 x 70 products) should be recognised. An asset of C60 (30% of product cost) will be established for the anticipated sales returns, while a liability of C300 (30% of product sale price) is established for the refund obligation. The effect of anticipated returns on inventory is presented on a gross basis rather than being offset against accounts receivable. The estimate of returns is re-evaluated at each reporting date. Any changes in estimated returns will require an adjustment to the corresponding asset and liability. Barter transactions Several entertainment and media subsectors engage in barter transactions, typically exchanging advertising for advertising, goods or services. The new standard could change how the transaction price is measured in some situations. New model Current US GAAP Current IFRS Revenue is recorded at the Advertising for advertising Advertising for advertising fair value of cash and noncash consideration received or Revenue and expenses Revenue is not recognised in promised from the customer. should be recorded at fair an exchange of similar goods The fair value is measured at value, if the fair value of the or services. However, if the the earlier of receipt of the advertising surrendered in the medium of advertising non-cash consideration by the transaction is determinable exchanged is dissimilar in entity or when (or as) the based on the entity s historical nature, revenue is recognised entity satisfies its performance practice of receiving cash, as the fair value of the obligations. If an entity is marketable securities or other advertising supplied. The fair unable to reasonably estimate consideration that is readily value of such advertising would These materials were downloaded from Inform ( under licence.page 148 / 307

149 the fair value of the non-cash consideration, it should measure the consideration indirectly by reference to the standalone selling price of the goods or services promised to the customer in exchange for the consideration. convertible to a known amount of cash for similar advertising from buyers unrelated to the counterparty in the barter transaction. If the fair value of the advertising surrendered in the barter transaction is not determinable, the barter transaction should be recorded based on the carrying amount of the advertising surrendered, which likely will be zero. Other than advertising for advertising Generally, non-monetary transactions should be based on the fair value of the assets or services involved, which is typically based on the fair value of the asset surrendered. The fair value of the asset received is used only if it is more clearly evident than the fair value of the asset surrendered. be measured by reference to similar nonbarter transactions. Other than advertising for advertising Revenue is measured at the fair value of the goods or services received, adjusted by the amount of any cash or cash equivalents received or paid. If the fair value of the goods or services received cannot be reliably measured, the revenue is measured at the fair value of the goods or services given up, adjusted by the amount of cash or cash equivalents received. Potential impact: Non-cash consideration should be recorded at fair value similar to current accounting. However, an entity must first look to the value of the good or service received as opposed to the good or service surrendered. This represents a change from current US GAAP that aligns with current IFRS. The new revenue recognition guidance has no specific guidance for advertising-for-advertising transactions, so additional judgement may be necessary to determine the fair value of such transactions when there is a limited market. Recognition is no longer precluded in the absence of cash-based transactions from others for similar advertising. Principal versus agent The determination of whether an entity is a principal or an agent will continue to require significant judgement. The principal/agent determination drives whether revenue is recorded on a gross or a net basis and therefore it significantly affects the amount of revenue recognised for many entertainment and media entities. New standard Current US GAAP Current IFRS An entity is a principal in an The determination of whether An entity is a principal if it is arrangement if it obtains an entity is a principal or an exposed to risks and rewards control of a good or service agent is based on the following when selling goods or before transferring it to a factors: providing services. customer. Obtaining title These materials were downloaded from Inform ( under licence.page 149 / 307

150 momentarily before transferring a good or service to a customer does not necessarily constitute control. An entity is an agent if its obligation is to arrange for another party to provide goods or services. Factors that may indicate that an entity is an agent, and therefore does not control a good or service before transferring to a customer, include: Another entity is responsible for fulfilling the contract. The entity does not have inventory risk. The entity does not have pricing latitude. The entity earns a commission. The entity does not have credit risk. Is the entity the primary obligor in the arrangement? Does the entity have general inventory risk? Does the entity have latitude in establishing pricing? Does the entity change the good or service? Is the entity involved in supplier selection? Is the entity involved in determining product specifications? Does the entity have physical inventory risk? Does the entity have credit risk? The first three factors above are considered to be weighted more heavily than the other factors. Indicators that an entity is acting as a principal in an arrangement are: The entity is the primary obligor. The entity has inventory risk. The entity has pricing latitude. The entity has credit risk. An indicator that an entity is an agent is if the entity earns a pre-determined fee. Potential impact: Entities will use many of the same criteria used today to determine if they should record revenue on a gross or net basis. However, as compared to US GAAP, the standard has fewer criteria and no longer weights some factors more than others. The purpose of the indicators under the new standard is to determine if the entity obtained control of a good or service before transferring to the customer. Principal versus agent determinations are common in the entertainment and media industry. For example: Determining if a publisher or a website is the principal with respect to the sale of an electronic book to a consumer. Determining if a producer or distribution studio is the principal with respect to These materials were downloaded from Inform ( under licence.page 150 / 307

151 film exploitation revenue. Determining if an internet advertiser or an agency is the principal in an advertising transaction. These judgements appear to be increasing in number and significance with the growth of digital business models which often involve no physical goods and little inventory or credit risk. Entities will need to reconsider the appropriate accounting for these and other transactions with respect to the modified criteria in the new standard. Deferral of costs Impact on current deferred or capitalised costs Existing US GAAP currently includes a substantial amount of guidance related to the capitalisation of costs specific to many entertainment and media subsectors, principally related to the cost of developing content. Such industry-specific guidance does not exist in IFRS, so IFRS entities follow the guidance for inventory or intangible assets to reach conclusions on capitalisation and amortisation. The revenue standard does not significantly affect existing guidance on the accounting for traditional content costs that are developed during the initial creative process and then expensed as the IP is exploited over time. Impact on other costs to obtain or fulfil a contract Incremental costs to obtain a contract will be capitalised if they are expected to be recovered. Such costs may be expensed as incurred as a practical expedient if the amortisation period of the asset is one year or less. This could result in additional deferred costs for certain subscription-based businesses which incur a commission or agency cost at the time of signing up a long-term subscription. Costs incurred to fulfil a contract should be assessed to determine if the accounting for those costs is in the scope of other standards. Costs incurred to fulfil a contract that are not in the scope of other standards are recognised as an asset under the new standard if the costs relate directly to a contract, generate or enhance resources of the entity that will be used to satisfy future performance obligations, and are expected to be recovered. Costs capitalised under the new standard will be amortised as control of the goods or services to which the asset relates is transferred to the customer. As discussed above, many costs to fulfil a contract are currently covered by other guidance within the entertainment and media space. The new deferral rules may apply in certain instances to producers that construct assets for studios or other users on a contract basis. About PwC s Entertainment and Media practice PwC s Global Entertainment and Media practice works with businesses to address both the challenges and opportunities presented by digital transformation, assisting them shift from traditional business models to businesses, brands and revenue streams that leverage digital content and platforms. We work with clients across a wide range of key industry sectors including: television, film, music, Internet, video games, advertising, publishing, radio, out of home advertising, sports, business information, casino gaming and more. Questions? PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in Accounting Consulting Services. These materials were downloaded from Inform ( under licence.page 151 / 307

152 Aerospace and defence industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for entities in the Aerospace and Defence (A&D) industry as they transition to the new standard. These areas include, but are not limited to, contract combinations, transfer of control, and contract costs. Overview The IASB and FASB developed a single, comprehensive revenue recognition model for all contracts with customers to achieve greater consistency in the recognition and presentation of revenue. The model in the new standard is a five-step model that results in an entity recording 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. Revenue is recognised based on the satisfaction of performance obligations, which occurs when control of a good or service transfers to a customer. The new revenue standard could significantly affect entities in the A&D industry. Currently, several accounting standards are commonly used to recognise revenue and related costs in the A&D industry. Defence and commercial aviation equipment programmes are often complex and expensive, and performance under these contracts typically spans multiple years. For entities reporting under US GAAP, these programmes generally follow construction contract guidance. Under IFRS, both the guidance under IAS 18, Revenue, and IAS 11, Construction contracts, are applied in practice. Long-term maintenance contracts for commercial aviation equipment and performance-based logistics contracts for military equipment are also common. These contracts can extend up to 20 years and require significant estimates of costs to perform under these contracts over the performance period. Identifying performance obligations Under current guidance, contractors often account for each contract in the scope of construction accounting at the contract level, except in circumstances where it meets the criteria for combining contracts or segmenting a contract. The new standard requires consideration of the separate performance obligations in a contract. A performance obligation is a promise to transfer a good or service to a customer. Determining the separate performance obligations might not be simple due to the complexity of A&D contracts. Contracts commonly contain integrated systems and combinations of products and services. New standard Current US GAAP Current IFRS Performance obligations At contract inception, an entity should assess The unit of accounting for measuring contract The unit of account for measuring contract These materials were downloaded from Inform ( under licence.page 152 / 307

153 the goods or services promised in a contract with a customer and identify as a performance obligation each promise to transfer to the customer either: A good or service (or a bundle of goods or services) that is distinct; or A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. This is the case if both the following criteria are met: Each distinct good or service in the series that the entity promises to transfer to the customer would be a performance obligation satisfied over time; and The same method would be used to measure the entity s progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer. performance and recognising revenue is typically the contract. A series of contracts may be combined or a contract may be segmented if the criteria for combining or segmenting contracts are met. There is no further guidance for separately accounting for more than one deliverable in a construction contract under the construction contract guidance. performance and recognising revenue is typically the contract. In some circumstances, it is necessary to combine or segment contracts in order to reflect the substance of the contract or of a group of contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract. Distinct goods or services A good or service (or bundle of goods or These materials were downloaded from Inform ( under licence.page 153 / 307

154 services) is distinct if both of the following criteria are met: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and The entity s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. Determining whether the good or service is distinct requires judgement. One factor that would indicate that the good or service is distinct is if the entity regularly sells a good or service separately. Factors that indicate a good or service is not distinct include: The entity provides a significant service of integrating the good or service with other promised goods and services. The good or service significantly modifies or customises another promised good or service. The good or service is highly dependent on, or highly interrelated with, other promised goods or services. Combining contracts Contracts will be combined and accounted for as a single contract only if they are entered into at or near the same time, with the same customer (or related parties), and one or more of the following criteria are met: The contracts are negotiated as a package with a single commercial objective. The amount of consideration to be paid in one contract depends on the price or Combining contracts is permitted, provided certain criteria are met. Combining is not required as long as the underlying economics of the transaction are fairly reflected. Combining contracts is required when certain criteria are met. These materials were downloaded from Inform ( under licence.page 154 / 307

155 performance of the other contract. The goods or services promised in the separate contracts are a single performance obligation. Contract options An option in a contract to acquire additional goods or services gives rise to a performance obligation only if it provides a material right to the customer that it would not have received without entering into the contract. For example, an option that provides a customer with a significant discount on goods or services in the future that is not available to similar customers is a material right. However, an option to buy additional goods or services at their stand-alone selling price is a marketing offer and therefore not a material right. If the option provides a material right, a portion of the transaction price is allocated to the option based on its estimated stand-alone selling price. An entity will recognise revenue allocated to the option when the option expires or when the additional goods or services are transferred to the customer. Contract options, which are generally an option to purchase additional units of a product at previously agreed-upon pricing, might be included in the original contract or accounted for separately, depending on the circumstances. When an option is determined to be substantive, an entity evaluates whether that option has been offered at a significant incremental discount. If the discount is significant, a presumption is created that an additional deliverable is being offered in the arrangement requiring a portion of the arrangement consideration to be deferred at inception. Contract options, which are generally an option to purchase additional units of a product at previously agreed upon pricing, might be included in the original contract or accounted for separately, depending on the circumstances. If an entity grants to its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, the entity accounts for that option as a separate component of the arrangement and therefore allocates consideration between the initial good or service provided and the option. Contract modifications (for example, change orders) A contract modification occurs when the parties approve a change that either creates new, or changes the existing, enforceable rights and obligations. Approval can be in writing, oral, or implied by customary business practices. Management will need to determine when a modification, such as a claim or unpriced change order, is approved and therefore creates enforceable rights and obligations. Revenue related to a modification is not recognised until it is approved. A contract modification is treated as a separate contract if it results in the addition of A change order is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. US GAAP includes detailed revenue and cost guidance on the accounting for unpriced change A change order (known as a variation) is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. There is no specific guidance on the accounting for unpriced change orders. These materials were downloaded from Inform ( under licence.page 155 / 307

156 a separate performance obligation and the price reflects the stand-alone selling price of that performance obligation. Otherwise, a modification (including those that only affect the transaction price) is accounted for as an adjustment to the original contract, either prospectively or through a cumulative catch-up adjustment. An entity will account for a modification prospectively if the goods or services in the modification are distinct from those transferred before the modification. An entity will account for a modification through a cumulative catchup adjustment if the goods or services in the modification are not distinct and are part of a single performance obligation that is only partially satisfied when the contract is modified. Impact both IFRS and US GAAP: orders (or those in which the work to be performed is defined, but the price is not). Preparers will need to apply judgement regarding the identification of performance obligations in a contract and when performance obligations should be separately accounted for or combined. This evaluation might cause fewer of an entity s contracts to be accounted for at the contract level. The new revenue guidance introduces the concept of determining whether a good or service (or a bundle of goods or services) is distinct. A good or service that is distinct will be accounted for as a separate performance obligation. A&D contracts often involve complex integrated systems. Judgement will be required to determine whether aspects of these systems represent a distinct good or service. If the criteria are met, contracts must be combined, which is a change from the election permitted under existing US GAAP, although the criteria used to combine contracts have not changed significantly. For entities reporting under IFRS, no significant change is expected, given that combining contracts is required under existing guidance if certain criteria, similar to those in the new revenue standard, are met. It is common in the A&D industry that customers often change the contract specifications and requirements, particularly for a development contract. The contractor is typically authorised to proceed with the changes, even though the price has not been finalised. Contract modifications under both current guidance and the new standard require judgement to determine whether they should be combined with the original contract. The accounting for modifications combined with the original contracts is not expected to change significantly compared to existing guidance under both IFRS and US GAAP. Example 1 Identifying performance obligations design and build Facts:A contractor enters into a contract to design a new experimental aircraft and manufacture ten identical prototype units of the aircraft. The new aircraft design includes certain key functionality that has not been proven in an aircraft application. It is expected that the design of the aircraft will be modified during production of the prototypes and that any given prototype might be modified based on the design changes and learnings from other prototypes. The deliverable to the customer is the prototype units; the customer does not obtain rights to the new These materials were downloaded from Inform ( under licence.page 156 / 307

157 aircraft design apart from the units. Are the design services and build of the prototypes distinct performance obligations? Discussion:The design services and manufacturing of the prototypes might be two distinct performance obligations, but the specific facts and circumstances of the contract will need to be assessed, such as whether the design activities represent the transfer of a service to the customer and whether the customer can benefit from the design services without the prototypes. Even if the services could be considered distinct, the contractor might still be required to account for the bundle of goods and services (design and build) as a single performance obligation if the contractor provides a significant service of integrating goods or services promised in the contract or if some of these goods and services significantly modify or customise others in the contract. In this particular fact pattern, the entity expects to continually modify the prototypes due to design changes that are expected to occur during production. While the design and production might have benefits on their own, in the context of the contract they are not separable. This is because the entity has determined that both are highly dependent on and highly interrelated with each other. Example 2 Identifying performance obligations series of distinct goods commercial contract Facts:A jet engine maker has a contract to provide engines for 50 twin-engine aircraft over a 36- month period. The engine specified in the contract is a fully developed engine that the engine maker has been manufacturing and selling for the past five years. Design services are not included in the contract. The engine maker has had other similar contracts to sell this specific engine in quantities that range from 20 to 100 engines per contract. Additionally, the engine maker routinely sells individual engines (unit of one) as spares and components of the engine as spare parts. The engine maker has concluded that each engine is a distinct good that is separately identifiable because (1) they are not providing a service of integrating the engine with another good or service that represents the combined output that the customer is contracting to receive; (2) the engines do not modify any other good or service in the contract; and (3) the engines are not highly interrelated with other engines such that a customer decision not to buy certain engines would not significantly affect the engines being purchased. How many distinct performance obligations are in the contract? Discussion: In this fact pattern, the engine maker has concluded that each engine is a distinct good. However, all 100 engines can still be considered a single performance obligation if (a) they are a series of engines that are substantially the same, and (b) each engine in the series transferred consecutively would meet the criteria to be a performance obligation satisfied over time, and the same method would be used to measure the entity s progress to depict the transfer of each engine. Determining whether each engine is a performance obligation satisfied over time will depend on the terms of the contract. In the case of a commercial contract, the customer does not typically control the asset as it is produced (unlike a government contract). The jet engine maker will need to assess whether the engine meets the criteria of no alternative use and right to payment to determine whether each engine meets the criteria to be a performance obligation satisfied over time. If the criteria are met, the 100 engines can be considered a single performance obligation. Refer to the Determining transfer of control section for guidance on measuring progress for a performance obligation satisfied over time. If the criteria for a performance obligation satisfied over time are not met, then each engine is a separate performance obligation. It is important to note that, while engine components are routinely sold, the integration of individual components within each engine is essential to what the contractor has promised to the customer in the contract. Therefore, the components do not represent separate performance obligations. The answer would likely be different if a customer was ordering a bundle of These materials were downloaded from Inform ( under licence.page 157 / 307

158 components to maintain engines it already operates. In that case, each component might be a separate performance obligation. Example 3 Identifying performance obligations series of distinct goods government contract Facts: A manufacturer has a contract to provide 50 communication equipment units to the government over a one-year period. The contractor has been manufacturing and selling this equipment for the past three years. The government controls the work in process as the units are being produced. The government does not have the ability to modify the design. The contractor has concluded that each unit is a distinct good that is separately identifiable because (1) they are not providing a service of integrating the unit with another good or service that represents the combined output that the government is contracting to receive; (2) the units do not modify any other good or service in the contract; and (3) the units are not highly interrelated with other units such that a customer decision not to buy certain units would not significantly affect the units being purchased. How many distinct performance obligations are in the contract? Discussion: The transfer of the 50 communication equipment units would likely be accounted for as a single performance obligation as (a) they are a series of units that are substantially the same, and (b) each unit in the series individually would meet the criteria to be a performance obligation satisfied over time and the same method would be used to measure the entity s progress to depict the transfer of each unit. Refer to the Determining transfer of control section for guidance on measuring progress for a performance obligation satisfied over time. Example 4 Unpriced change orders Facts: A contractor enters into a contract with a customer to develop an aircraft system. After development starts, the customer changes the specifications of the system. The contractor is asked to process the changes; however, the price has not yet been approved and is not expected to be approved before the development is completed. These types of changes are common and the contractor has a history of executing unpriced change orders. When should the contractor account for these change orders? Discussion:The changes in the system specifications should be accounted for when a contract modification exists. A contract modification, such as an unpriced change order, exists when the parties to the contract approve a modification that creates or changes the enforceable rights and obligations of the parties. Determining whether there is a valid expectation that the price modification will be approved is based on facts and circumstances. The contractor might be able to determine that it expects the price of the scope change to be approved based on its experience. If so, the contractor should account for the changes in the system specifications upon making that determination. The contractor should estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is most predictive), provided that it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur when the price of the change order is approved (refer to the Variable consideration and the constraint on revenue recognition section). Estimates of unpriced change orders need to be re-evaluated at each reporting period. The contractor will also need to determine whether the unpriced change order should be accounted for as a separate contract. When a change order is combined with the original contract and the remaining goods or services are part of a single performance obligation that is partially satisfied, the contractor should update the transaction price and measure of progress towards completion of the contract accordingly. The contractor will recognise the effect of the contract modification as revenue (or as a reduction of revenue) at the date of the contract modification on a cumulative catch-up basis. These materials were downloaded from Inform ( under licence.page 158 / 307

159 Variable consideration and the constraint on revenue recognition The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. The transaction price might include an element of consideration that is variable or contingent on the outcome of future events. Examples of arrangements in the A&D industry with variable consideration include contracts with awards and incentive fees for achieving a successful outcome or completion by a specific date. New standard Current US GAAP Current IFRS Awards and incentive fees Awards/incentive payments are estimated using either a probability-weighted approach or an estimate of the most likely amount (whichever is more predictive). Awards/incentive payments should be included in the transaction price to the extent that it is highly probable (IFRS) or probable (US GAAP) that a significant cumulative revenue reversal will not occur in future periods if estimates of the variable consideration change. Factors that could increase the likelihood or the magnitude of a revenue reversal include: Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be estimated. Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. The amount of consideration is highly susceptible to factors outside the entity s influence. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time. The entity s experience (or other evidence) with similar types of contracts is limited, or that These materials were downloaded from Inform ( under licence.page 159 / 307

160 Claims experience has limited predictive value. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. The contract has a large number and broad range of possible consideration amounts. Entities can submit claims to their customers for additional transaction consideration due to costs being higher than expected. Claims that can affect the amount of consideration that an entity is entitled to receive in exchange for transferring goods or services are accounted for as variable consideration. The treatment of such claims is similar to the treatment for awards/incentive fees above. Impact both IFRS and US GAAP: A claim is recorded as contract revenue when it is probable and can be estimated reliably (determined based on specific criteria), but only to the extent of contract costs incurred. Profits on claims are not recorded until they are realised. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable that the customer will accept the claim and the amount can be reliably measured. The evaluation of variable consideration will require judgement. In some cases, revenue will be recognised before all contingencies are resolved, which might be earlier than under current guidance. Entities might need to recognise the minimum amount of revenue that they expect to be entitled to when control transfers, as long as it is highly probable (IFRS) or probable (US GAAP) that the amount of cumulative revenue recognised is not subject to a significant reversal of cumulative revenue in the future if estimates of variable consideration change. Using a most likely or probability-weighted estimate approach to determine the transaction price in arrangements involving bonuses, claims, and award fees might provide results similar to today when estimating the contract price under the construction contract guidance. These materials were downloaded from Inform ( under licence.page 160 / 307

161 Example 5 Award fees Facts: A contractor enters into a contract for a satellite launch for the government. The contract price is C250 million plus a C25 million award fee if the system is placed into orbit by a specified date. The contract is expected to take three years to complete. The contractor has a long history of rocket launches. The award fee is binary and payable in full upon successful launch of the satellite. That is, the contractor will receive no award fee if the launch is unsuccessful. The contractor believes, based on its long history of relevant experience with similar programmes, that it is 95 percent likely that the contract will be completed successfully and in advance of the target date. How should the contractor account for the award fee? Discussion: The contractor is likely to conclude, given the binary award fee, that it is appropriate to use the most likely amount approach in determining the amount of variable consideration to include in the estimate of the transaction price. The contract s transaction price is therefore C275 million: the fixed contract price of C250 million plus the C25 million award fee (the most likely amount). This estimate should be regularly revised and adjusted, as appropriate, using a cumulative catch-up approach, which is consistent with current practice. The contractor will need to determine whether it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur in the future. Significant is not defined in the standard. Factors to consider include, but are not limited to: It is largely within the contractor s control to complete the work before the targeted date. The uncertainty is expected to be resolved before three years. The contractor has a long history of performing this type of work on similar programmes. The contractor does not expect that the payment terms will change. There are only two possible final consideration amounts. The contractor might conclude in these circumstances that it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur in the future. The new guidance should not result in a significant change from today s accounting for variable consideration in many A&D contracts, but an assessment will need to be made based on the specific facts and circumstances of each contract. Example 6 Claims Facts: Assume the same fact pattern as Example 5, except that, due to reasons outside the contractor s control (for example, customer-caused delays and design changes), the cost of the contract far exceeds original estimates, but a profit is still expected in the contract. The contractor submits a claim against the government to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with the government. How should the contractor account for the claim? Discussion: Claims are highly susceptible to external factors (such as the judgement of third parties), and the possible outcomes are highly variable. The contractor might have experience in successfully negotiating claims; however, before the contractor can include claims in its estimate of contract price, it would have to assess whether (1) the claim is enforceable under the contract, and (2) it is probable that a significant reversal in the amount of cumulative revenue recognised will not occur once the claim is resolved. The contractor would evaluate factors such as whether the amount of consideration is highly susceptible to factors outside their control, These materials were downloaded from Inform ( under licence.page 161 / 307

162 relevant experience with similar claims and the period of time before resolution of the claim to determine the likelihood or magnitude of a revenue reversal. The amount of the claim is excluded from the transaction price until the contractor believes that it is highly probable (IFRS) or probable (US GAAP) that the amount would not be subject to significant reversal of cumulative revenue in future periods. For performance obligations satisfied over time, this results in the claim amount being excluded from the calculation of revenue when the measure of progress is applied. Amounts from claims are likely to be included in the transaction price at a date closer to the date when the claim is expected to be resolved. It could be highly probable (IFRS) or probable (US GAAP) that some portion of the claim would not result in a significant cumulative revenue reversal, for example, if an entity has a history of successful negotiations. In such cases, the contractor would include that minimum amount in the estimate of transaction price. Existence of a significant financing component Long-term contracts with various payment terms are common in the A&D industry. Under the new revenue standard, companies will need to assess the timing of customer payments in relation to the transfer of goods or services. Differences in timing could indicate that a significant financing component exists, either with the entity or its customer, which should be reflected in the transaction price. This could result in the company recognising interest income or expense, and total revenue could be more or less than the consideration received. New standard Current US GAAP Current IFRS Contract revenue should Receivables are discounted in Receivables are discounted reflect the time value of money limited situations, including when the inflow of cash or cash if the contract includes a significant financing component. Entities should consider the following factors to determine if a significant financing component exists: receivables with payment terms longer than one year. The interest component is computed based on the stated rate in the agreement or on a market rate when discounting equivalents is deferred. An imputed interest rate is used to determine the amount of revenue recognised as well as the interest income recorded over time. is required. The difference, if any, between the amount the customer promises to pay and the cash selling price of the goods or services. The length of time between when the entity satisfies the performance obligation and when the customer pays for the goods or These materials were downloaded from Inform ( under licence.page 162 / 307

163 services, and the prevailing interest rates in the market. All relevant facts and circumstances should be considered when assessing if a contract contains a financing component, including whether the intent of the parties is to provide financing. Management should use a discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception, including consideration of credit risk. The discount rate does not need to be updated subsequent to contract inception. An entity is not required to reflect the time value of money in the transaction price when the period between payment by the customer and the transfer of goods and/or services is less than one year, even if the contract itself is for more than one year. Impact both IFRS and US GAAP: Assessing whether a contract has a significant financing component will require judgement. An entity must determine when goods or services are transferred to the customer compared to when consideration is paid to determine if a significant financing component might exist. If there is a difference between performance and payment of one year or more, an entity will need to consider other factors to assess whether the intent of the parties was to provide financing. A&D contract terms often contain provisions for the contractor to receive progress payments as work progresses. Progress payments that are commensurate with the progress towards completion generally indicate that there is not a significant financing component in the contract. This is typical in government contracts where the government obtains control of the goods as the work is performed. However, in some commercial contracts, transfer might occur at a point in time, which could result in a timing difference greater than one year. For example, in the case of a contract for the sale of an aircraft where control to the customer transfers as delivered, significant upfront or progress payments could indicate that the contract includes a significant financing component. A significant financing component might not be present if the timing difference is due to reasons other than providing financing, such as award and incentive fees or other payments made to protect one party from the other failing to complete its obligations under the contract. These materials were downloaded from Inform ( under licence.page 163 / 307

164 Long-term maintenance contracts for commercial aerospace equipment often include significant timing differences between payment and performance. Entities will have to consider whether a significant financing component exists in the contract and, if so, the effect on the transaction price. Some maintenance contracts that are common in the A&D industry provide for monthly billings to the customer based on product usage or aircraft flight hours, with revenue recognised at the time that the maintenance of the product is performed. Reflecting the time value of money could be complex, given the multiple cash payments and revenue recognition events over the life of a contract. Determining transfer of control Entities in the A&D industry often use percentage-of-completion accounting to recognise revenue as activities are performed. Percentage of completion is measured using either output methods, such as units of delivery, or input methods, such as cost incurred compared to total estimated cost. Under the new revenue standard, revenue is recognised upon the satisfaction of a contractor s performance obligations, which occurs when (or as) control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. Many A&D contracts will transfer control of a good or service over time. Depending on the measure used to depict progress, applying the new standard might result in revenue being recognised in a pattern similar to today. This should not be assumed. Contractors will need to perform a careful assessment of when control transfers and revenue can be recognised. New standard Current US GAAP Current IFRS Transfer of control Revenue is recognised upon the satisfaction of performance obligations, which occurs when (or as) control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps more common for the A&D industry, over time. Transfer over time A performance obligation is satisfied over time if any of the following criteria are met: The customer simultaneously receives and consumes all of the benefits provided by the entity s performance as the entity performs. The entity s performance creates or Revenue is recognised using the percentage-of-completion method when reliable estimates are available. When estimating the final outcome of a contract is impractical, but there is an assurance that no loss will be incurred, the percentage-ofcompletion method based on a zero-profit margin is used until more precise estimates can be made. The completed-contract method is required when reliable estimates cannot be made. Revenue is recognised using the percentage-of-completion method when reliable estimates are available. When reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract, the percentage-of-completion method based on a zero-profit margin is used until more precise estimates can be made. The completed-contract method is prohibited. These materials were downloaded from Inform ( under licence.page 164 / 307

165 enhances an asset (work-inprogress) that the customer controls as the asset is created or enhanced. The entity s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date. Alternative use An asset does not have alternative use to an entity if the entity is unable, either contractually or practically, to readily direct the asset for another use during the creation or enhancement of that asset. The assessment of alternative use is made at contract inception and is not updated for changes in facts or circumstances unless the parties to the contract approve a contract modification. Right to payment At any time throughout the duration of the contract, the entity must be entitled to an amount that at least compensates the entity for performance completed to date if These materials were downloaded from Inform ( under licence.page 165 / 307

166 the contract is terminated for reasons other than the entity s failure to perform as promised. The right to payment for performance completed to date does not need to be for a fixed amount. Transfer at a point in time An entity will recognise revenue at a point in time (when control transfers) if performance obligations in a contract do not meet the criteria for recognition of revenue over time. Determining at what point in time control transfers could require a significant amount of judgement. Indicators that control has transferred to a customer include: The entity has a right to payment for the asset. The entity transferred legal title to the asset. The entity transferred physical possession of the asset. The customer has the significant risk and rewards of ownership. The customer has accepted the asset. This list is not intended to be a checklist or all-inclusive. In evaluating when control has transferred, no factor is determinative on a stand-alone basis. These materials were downloaded from Inform ( under licence.page 166 / 307

167 Measuring transfer of control over time A contractor should measure progress towards satisfaction of a performance obligation that is satisfied over time using the method that best depicts the transfer of goods or services to the customer. Methods for measuring progress include: Output methods that recognise revenue based on units produced or delivered, contract milestones, or surveys of work performed. Input methods that recognise revenue based on costs incurred, labour hours expended, time elapsed, or machine hours used. Outputs methods such as units produced or units delivered might not faithfully depict an entity s performance if, at the end of the reporting period, the value of work-in-progress or finished goods controlled by the customer is material, or if the contract provides both design and production services. In such a case, the entity s performance is likely to have a greater value in the early part of the contract. The method selected should be applied consistently to similar contracts and in similar circumstances. Once the metric is calculated to measure the extent to which control has A contractor can use either an input method (for example, cost-to-cost, labour hours, labour cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. There are two different approaches for determining revenue, cost of revenue, and gross profit, once a percentage complete is derived: the Revenue method, and the Gross Profit method. A contractor can use either an input method (for example, cost-to-cost, labour hours, labour cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. IFRS requires the use of the Revenue method to determine revenue, cost of revenue, and gross profit once a percentage complete is derived. The Gross Profit method is prohibited. These materials were downloaded from Inform ( under licence.page 167 / 307

168 transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognised. When using an input method, the effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. In some circumstances, it might be appropriate to recognise revenue equal only to the costs incurred if those costs do not represent the entity s progress (such as materials procured by a third party that are not distinct and that the customer controls before the entity provides the related services). An entity should recognise revenue over time only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation. If an entity cannot reasonably measure its progress, but expects to recover its costs, it should recognise revenue to the extent of costs incurred until it can reasonably measure progress. Estimates to measure progress (for example, estimated cost to complete when using a cost-tocost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method. Impact both IFRS and US GAAP: A&D entities will need to assess their contracts to determine whether control of the asset(s) being constructed transfers over time to the buyer. Government contracts commonly require highly customised engineering and production where the government specifies the design and function of the items being produced. The products and services often have only a single customer (the government) or require government approval to sell to other customers. Government contracts also commonly require progress payments and an unconditional obligation to pay in exchange for the government controlling any work in process. Many A&D government contracts will likely meet the criteria for transfer of control over time due to these factors. These materials were downloaded from Inform ( under licence.page 168 / 307

169 Commercial aerospace contracts also commonly include highly customised systems and components that are integrated with the aircraft design and are unique to a specific aircraft model. Whether these contracts result in the transfer of the goods or services over time will be a matter of judgement depending on the nature of the product, the contract terms, and related facts and circumstances. The new revenue guidance allows both input and output methods for recognising revenue over time. An entity should select the method that best depicts the transfer of control of goods and services. Some government contractors have historically used the units-of-delivery method to measure progress of completion of a contract. However, under the new standard, units-ofdelivery or units-of-production methods would not faithfully depict an entity s performance in satisfying a performance obligation if, at the end of the reporting period, the entity s performance has produced work in process or finished goods controlled by the customer that are not included in the measurement of the output. Accordingly, if an entity s work in process is material (to the contract or to the financial statements as a whole), it will likely need to use a method other than units-of-delivery. This could result in a change from the method that some entities use today in both government and commercial contracts. The Gross Profit method of calculating revenue, costs of revenue, and gross profit based on the percentage complete will no longer be acceptable, which is a change from current US GAAP. The Gross Profit method is already prohibited under existing IFRS. Example 7 Transfer of control over time government contract Facts:A contractor enters into a contract with a government to build an advanced radar and weapons system. The contract has the following characteristics: The radar and weapons system is designed to the government s specifications that, due to the proprietary technology used, cannot be transferred to any other government or customer without approval. The government makes non-refundable progress payments to the contractor. The government can terminate the contract at any time, but is required to pay for work performed. The government has a lien against work in process; if the contractor terminates the contract, the government gets title of the work in process. Physical possession and title do not pass to the government until completion of the contract. The contractor determined that the contract is a single performance obligation because the contractor is providing a service to integrate all elements of the project into a single item for the government. Also, the contractor determined that, given the lien on work in process, the government controls such work in process. How should the contractor recognise revenue in this example? Discussion:The contractor is constructing an asset and providing the related services associated with that project over the contract term. The contractor will recognise revenue as the performance obligation is satisfied over time, using a measure of progress that best depicts the transfer of control. Given that the government controls the work in progress as the asset is constructed, the contractor will likely use an input measure (for example, cost-to-cost) to depict transfer of control as the work is performed. It is presumed that an input measure would be used, because an output measure does not take into account work in progress (or inventory) that belongs to the government. These materials were downloaded from Inform ( under licence.page 169 / 307

170 Example 8 Transfer of control at a point in time commercial contract Facts:A manufacturer enters into a contract with a customer to produce 20 engines to be used on commercial aircraft. The customer orders a standard engine model produced by the manufacturer. The manufacturer does not produce engines in advance of future orders and only starts production when an order is placed. The contract has the following characteristics: The customer is required to make progress payments over the period of production. These payments are refundable in the event of a cancellation, but the contract also provides for termination penalties in the event of contract cancellation. The customer can cancel the contract at any time, and any work in process remains the property of the manufacturer. Title to the engines passes to the customer upon shipment of each engine. How should the manufacturer recognise revenue in this example? Discussion: Given that the customer does not have physical possession, have a lien or take title to the work in process, the manufacturer will need to consider whether the engines have an alternative use and whether it has a right to payment. Each engine might have an alternative use to the manufacturer as the model is sold to other customers, provided that the contract does not preclude the manufacturer from selling it to another customer and that costs for any rework to resell it are not significant in relation to the overall cost of the engine. If the engines have an alternative use, each engine will be considered a performance obligation satisfied at a point in time when the control of the engines transfers to the customer, which is likely to be upon shipment of each engine. Revenue will be recorded at a point in time when each performance obligation is satisfied. Contract costs Existing construction contract guidance contains a substantial amount of cost capitalisation guidance, related to both pre-contract costs and costs to fulfil a contract. The new revenue standard includes contract cost guidance that could result in a change in the measurement and recognition of contract costs as compared to today. New standard Current US GAAP Current IFRS Incremental costs of obtaining There is a significant amount a contract are capitalised if the of detailed guidance relating to costs are expected to be the accounting for contract recovered. Incremental costs costs within the construction of obtaining a contract are contract guidance. This is costs that the entity would not particularly true with respect to have incurred if the contract accounting for pre-contract had not been obtained. Such costs. costs can be expensed as incurred if the amortisation period is less than one year. Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained are Pre-contract costs that are incurred for a specific anticipated contract generally may be deferred only if their recoverability from that contract is probable. There is a significant amount of detailed guidance relating to the accounting for contract costs. Costs that relate directly to a contract and are incurred in securing the contract are included as part of contract costs if they can be separately identified, measured reliably, and it is probable that the contract will be obtained. These materials were downloaded from Inform ( under licence.page 170 / 307

171 recognised as an expense when incurred (for example, marketing expenses or employees fixed salaries), unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. Direct costs incurred to fulfil a contract are first assessed to determine if they are in the scope of other standards (for example, those addressing inventory, intangibles, or fixed assets), in which case the entity should account for such costs in accordance with those standards (either capitalise or expense). Costs that are not in the scope of another standard are evaluated under the revenue standard. An entity recognises an asset only if the costs relate directly to a contract, generate or enhance resources of the entity that will be used to satisfy future performance obligations, and are expected to be recovered under the contract. Costs that relate directly to a contract include costs that are incurred before the contract is obtained if those costs relate to an anticipated contract that the entity can specifically identify. All costs relating to satisfied performance obligations and costs related to inefficiencies (that is, abnormal costs of materials, labour, or other costs to fulfil) are expensed as incurred. Capitalised costs to obtain or fulfil a contract are amortised on a systematic basis consistent with the pattern of transfer of goods or services to which the asset relates. The amortisation period might Entities may recognise costs based on the average cost per unit, using estimates of total costs over the life of the contract. The average cost method often results in the deferral of contract costs that are subsequently recognised as cost of sales as additional performance takes place under the contract. These materials were downloaded from Inform ( under licence.page 171 / 307

172 include specific anticipated contracts (for example, contract renewals). The asset recognised for the incremental costs of obtaining or fulfilling a contract should be periodically assessed for impairment. An impairment loss is recognised in profit or loss if the carrying amount of the asset exceeds: The remaining amount of consideration that the entity expects to receive in exchange for the goods or services to which the asset relates; less The remaining costs of providing those goods or services. Impact both IFRS and US GAAP: A&D entities that use the average cost method or otherwise defer costs under current guidance might be affected by the new standard. Costs in the scope of another asset standard must be accounted for under that standard (which might require capitalisation or expensing as incurred). This could result in more items being expensed than under today s guidance. An asset recognised for contract costs under the new revenue guidance might relate to both a contract and another specific anticipated contract. The asset would then be amortised over a period greater than the initial contract period. Costs attributable to each performance obligation under the contract will generally be expensed as that individual performance obligation is satisfied. Application of the standard to learning curve costs will require judgement. Certain learning curve costs not in the scope of another asset standard might meet the criteria for capitalisation under the new standard, while others might not. Demonstrating that learning costs relate to future performance obligations could be difficult and might result in some of those costs being expensed as incurred. Example 9 Contract costs These materials were downloaded from Inform ( under licence.page 172 / 307

173 Facts: A contractor enters into a contract to design and build a complex missile defence system for a foreign government. Performance of the contract is expected to occur over a three-year period. The contractor utilised a third-party sales agent to help negotiate the contract. The contractor pays the agent a one-time agency fee (commission) upon successful awarding of the contract to the contractor. The contractor concludes that the contract includes a single performance obligation satisfied over time. The contactor applies a cost-to-cost method of recognising revenue. How should the contractor account for the commission paid to the agent? Discussion: The new revenue guidance requires incremental costs to acquire a contract to be capitalised and amortised over the related performance period which, in this example, would be as the missile system is built. Example 10 Learning curve costs Facts: A contractor enters into a contract to manufacture aerospace components for a customer that are substantially the same. The contractor determines that each component meets the criteria to be a single performance obligation satisfied over time, because any work in process is controlled by the customer. The same method would be used to measure the contractor s progress towards manufacturing each component. This results in the contractor having a series of components with the same pattern of transfer, and therefore a single performance obligation satisfied over time. The contractor estimates that each component will cost C80,000, on average, to manufacture, and it prices the contract at C100,000 per component, or C1 million. The contractor previously developed the required technology to manufacture the aerospace components, but this is its first production contract. The first two components are expected to cost C95,000 to manufacture due to the learning curve involved. How should the contractor account for revenue and cost for this contract? Discussion: The terms of the contract result in the entity having a single performance obligation that is satisfied over time. Revenue is recognised using an appropriate measure that depicts the transfer of control. The contractor has concluded that an input measure (for example, cost-tocost) is the most appropriate measure of progress. This will result in the contractor recognising more revenue and expense for the first components produced as compared to the later components. This effect is appropriate, given that the contractor would likely charge a higher price to a customer purchasing only one unit as compared to the average unit price charged when the customer purchases more than one unit. If the contractor determines that revenue should be recognised at a point in time (upon delivery of each product), a different conclusion could be reached. The learning curve costs would need to be assessed under other guidance, such as inventory guidance, and if they are not addressed by other standards, they would need to be assessed under the revenue guidance. Onerous contracts Existing guidance for construction contracts under both IFRS and US GAAP requires recording anticipated losses when they become evident. This assessment is made at the contract level and measured based on the estimated contract revenue compared with the costs to complete the contract. The new standard does not include any new guidance on accounting for onerous contracts. Existing guidance related to onerous contracts will therefore continue to be applicable for entities using contract accounting. Long-term maintenance contracts Long-term maintenance contracts are common in the A&D industry. The accounting for such contracts is similar to extended or separately priced warranties in many instances, which are accounted for as separate performance obligations under the new standard similar to service These materials were downloaded from Inform ( under licence.page 173 / 307

174 contracts. Judgement will be needed to determine whether a long-term maintenance arrangement represents a single performance obligation satisfied over time or multiple distinct performance obligations, each satisfied when the maintenance event occurs. Contracts to perform an unspecified number of maintenance events over a period of time are likely to result in a single performance obligation satisfied over time. Contracts to perform each maintenance event at a specified price per event are likely to result in separate performance obligations for each maintenance activity. Example 11 Long-term maintenance agreement Facts: A company enters into a contract to sell an aerospace component system to a customer, and agrees to maintain that system for a period of 10 years once the system is operational. These systems are often sold in the market without the extended maintenance contract, and the maintenance contract can also be purchased separately for an additional cost. How should the company record revenue for this contract? Discussion: There are likely two performance obligations in this contract: one to deliver the aerospace component system, and a separate performance obligation for the extended maintenance. The maintenance is a separate performance obligation because it could be purchased separately by the customer. The total transaction price should be allocated to the two performance obligations based on their relative stand-alone selling prices. The aerospace component system is likely a performance obligation satisfied at a point in time, with revenue recognised when control of the product is transferred to the customer. The maintenance performance obligation is likely satisfied over time, with revenue recognised based on an appropriate measure of progress. Transition Entities will apply the new revenue standard in the first interim period within annual reporting periods beginning on or after 1 January 2017 (IFRS) and 15 December 2016 (US GAAP). Earlier adoption is permitted under IFRS, but not under US GAAP. For non-public entities (US GAAP only), the standard is effective for annual reporting periods beginning after 15 December 2017 and for interim reporting periods within annual reporting periods beginning after 15 December Earlier application is permitted for non-public entities, but no earlier than reporting periods beginning on or after 15 December Entities can apply the new revenue standard retrospectively. Entities applying the retrospective method can elect certain practical expedients, such as not restating contracts that begin and end in the same period and using hindsight in accounting for variable consideration in completed contracts. Entities can also choose to use the following method to simplify transition, provided that they disclose this fact in their financial statements: Apply the revenue standard to all existing contracts as of the effective date and to contracts entered into subsequently. Recognise the cumulative effect of applying the new standard to existing contracts in the opening balance of retained earnings on the effective date. In the year that the standard is initially adopted, provide the following additional disclosures, beginning with the first interim period: the amount by which each financial statement line item is affected in the current reporting period as a result of the entity applying the new revenue standard; and an explanation of the significant changes between the reported results under the new revenue standard and legacy These materials were downloaded from Inform ( under licence.page 174 / 307

175 guidance. Entities will need to consider the impact of the new guidance on contract costs as part of the transition process. For all existing contracts as of the effective date, entities will need to account for the related contract costs in accordance with the new standard. Some entities might have to recognise an asset as of the transition date for expenses already incurred prior to transition if those expenses would be capitalised under the new standard. About PwC s Aerospace & Defence practice Our Aerospace & Defence (A&D) practice provides industry-focused assurance, tax, and advisory services to leading A&D companies around the world. We help A&D companies address a full spectrum of industry-specific advisory challenges across areas such as the globalisation of A&D, operational improvement, supply chain management, compliance, export controls, government contracting and full scope information technology. We actively leverage our diverse institutional knowledge, experience, and solutions to provide fresh perspectives and significant value for our clients. Questions? PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in Accounting Consulting Services. Technology industry supplement At a glance On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth is a comprehensive analysis of the new standard. This supplement highlights some of the areas that could create the most significant challenges for technology entities as they transition to the new standard. Overview The technology industry comprises numerous subsectors, including, but not limited to, computers and networking, semiconductors, software and internet, and clean technology. Each subsector has diverse product and service offerings and various revenue recognition issues. Determining how to allocate consideration among elements of an arrangement and when to recognise revenue can be extremely complex and, as a result, industry-specific revenue recognition models were previously developed. The new revenue standard replaces these multiple sets of guidance with a single revenue recognition model, regardless of industry. While the new standard includes a number of specific factors to consider, it is a principles-based standard. Accordingly, companies should ensure that revenue recognition is ultimately These materials were downloaded from Inform ( under licence.page 175 / 307

176 consistent with the substance of the arrangement, and not just based on meeting the specified factors. The following provides a summary of some of the areas within the technology industry that may be significantly affected by the new revenue standard and highlights the technology subsectors where these issues are most commonly seen. The revenue standard is effective for entities that report under IFRS for annual periods beginning on or after 1 January Early adoption is permitted for IFRS reporters. The revenue standard is effective for the first interim period within annual reporting periods beginning after 15 December 2016 for US GAAP public reporting entities and early adoption is not permitted. It will be effective for annual reporting periods beginning after 15 December 2017 and interim periods within annual periods beginning after 15 December 2018 for US GAAP nonpublic entities. Earlier application is permitted for non-public entities; however, adoption can be no earlier than periods beginning after 15 December Multiple-element arrangements Many technology companies provide multiple products or services to their customers as part of a single arrangement. Hardware vendors sometimes sell extended maintenance contracts or other service elements along with the hardware, and vendors of intellectual property licences may provide professional services in addition to the licence. Management must identify the separate performance obligations in an arrangement based on the terms of the contract and the entity s customary business practices. A bundle of goods and services might be accounted for as a single performance obligation in certain fact patterns. The revenue recognition criteria are usually applied separately to each transaction. It might be necessary to separate a transaction into identifiable components in order to reflect the substance of the transaction in certain circumstances. New standard Current US GAAP Current IFRS A performance obligation is a promise in a contract to transfer to a customer either: A good or service (or a bundle of goods or services) that is distinct; or A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A good or service is distinct if both of the following criteria are met: The following criteria are applied to transactions other than those involving software (refer to separate discussion below related to software companies) to determine if elements included in a multiple-element arrangement should be accounted for separately: The delivered item has value to the customer on a stand-alone basis. If a general return right exists for the delivered item, delivery or These materials were downloaded from Inform ( under licence.page 176 / 307 Two or more transactions might need to be grouped together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. Expected impact: Technology companies will need to assess whether contracts include multiple performance obligations. Management will need to evaluate whether to account for a bundle of goods or services as a single performance obligation, which may require judgement. The guidance for identifying distinct goods and services in the new standard is more specific and may result in more (or, in some cases, fewer) performance obligations being identified.

177 The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (for example, because the entity regularly sells the good or service separately). The good or service is separately identifiable from other goods or services in the contract. performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. Expected impact: Technology companies will need to assess whether contracts include multiple performance obligations. Management will need to evaluate whether to account for a bundle of goods or services as a single performance obligation, which may require judgement. Indicators provided in the standard will need to be applied to make this determination. Factors that indicate that a good or service in a contract is separately identifiable include, but are not limited to: The entity is not using the good or service as an input to produce the combined output specified by the customer. The good or service does not significantly modify or customise another good or service promised in These materials were downloaded from Inform ( under licence.page 177 / 307

178 the contract. The good or service is not highly dependent on, or highly interrelated with, other promised goods or services. Sectors in technology most impacted Software Cloud Internet Semiconductors Hardware / Clean-tech Computing Equipment?????? Example 1 Sale of software and implementation services separate performance obligations Facts: Vendor licenses ERP software to Customer. Vendor also agrees to provide services to implement the software by performing set-up activities for Customer. Customer can use the Vendor for the implementation services or another service provider. Further, the implementation services are not considered to reflect a significant customisation or integration of the software. How should Vendor account for the transaction? Discussion: Vendor should account for the licence and services as separate performance obligations. Vendor is providing a licence to the ERP software and implementation services to Customer. Customer has the ability to obtain the implementation services from another vendor or do the work itself, and the implementation services do not reflect a significant customisation or integration of the software. The licence and implementation services are distinct because Customer can benefit from the ERP software on its own or together with readily available resources, and the promise to deliver the licence is separately identifiable from the promise to provide implementation services. Refer to the Consulting and manufacturing service contracts and Intellectual property licences sections later in this supplement for when revenue should be recognised. Example 2 Sale of software and customisation/integration services single performance obligation Facts: Vendor licenses customer relationship management software to Customer. Vendor also agrees to provide services to significantly customise the software to Customer s information technology environment. Only Vendor can provide this customisation and integration service. How should Vendor account for the transaction? Discussion: Vendor should account for the licence and services together as a single performance obligation. Vendor is providing a significant service of integrating the licence and the services into the combined item for which the customer has contracted (a customised customer relationship management system). The software is also significantly customised by the vendor in accordance with the specifications negotiated with Customer. The licence and services are not distinct, because Customer cannot benefit from the software on its own or together with readily available resources, and the promise to deliver the licence is not separately identifiable from the promise to provide implementation services. Refer to the Consulting and These materials were downloaded from Inform ( under licence.page 178 / 307

179 manufacturing service contracts and Intellectual property licences sections later in this supplement for when revenue should be recognised. Example 3 Sale of hardware and installation services separate performance obligations Facts:Vendor enters into a contract to provide hardware and installation services to Customer. Vendor always sells the hardware with the installation service, but Customer can perform the installation on its own or can use other third parties. How should Vendor account for the transaction? Discussion:Vendor should account for the hardware and installation services as separate performance obligations. The hardware and installation service are not sold separately by Vendor; therefore, management will need to evaluate whether the customer can benefit from the hardware on its own or together with readily available resources. Customer can either perform the installation itself or use another third party; thus, Customer can benefit from the hardware on its own. As the installation service does not significantly integrate, modify, or customise the equipment, the Vendor s promise to transfer the equipment is separately identifiable from the Vendor s promise to perform the installation service. Accordingly, the equipment and the installation are distinct and accounted for as separate performance obligations. Vendor would generally recognise revenue allocated to the hardware when it transfers control of the hardware to Customer. Refer to the Consulting and manufacturing service contracts section later in this supplement for when revenue allocated to the installation service should be recognised. Elimination of software-specific guidance The new standard will replace all industry-specific revenue guidance, including software revenue recognition guidance under US GAAP. The elimination of existing guidance will have an especially significant impact on the accounting for software and software-related transactions. New standard Current US GAAP Current IFRS Software arrangements involving multiple elements As discussed above, the new standard requires entities to identify separate performance obligations in a contract. The transaction price is allocated to separate performance obligations based on their relative stand-alone selling prices. Management should estimate the stand-alone selling price if it does not separately sell a good or service on a stand-alone basis. The residual approach may be used for determining the stand-alone selling price of a good or service if the pricing of that good or service is highly variable or uncertain. A selling price is highly variable if an Contract consideration is allocated to the various elements of an arrangement based on vendor-specific objective evidence (VSOE) of fair value, if such evidence exists for all elements in the arrangement. Revenue is deferred when VSOE of fair value does not exist for undelivered elements until the earlier of: (a) when VSOE of fair value for the undelivered element does exist; or (b) all elements of the arrangement have been delivered. Expected impact: VSOE of fair value, which is a high hurdle, will no longer be required for undelivered items in order to These materials were downloaded from Inform ( under licence.page 179 / 307 Revenue is allocated to individual elements of a contract, but specific guidance is not provided on how to allocate the consideration or for software arrangements. Separating the components of a contract might be necessary to reflect the economic substance of an arrangement. IFRS does not define identifiable components of a single transaction. The assessment of components and future obligations is a matter of judgement (regardless of whether the obligation is specifically stated in the contract or implied). While the application of IFRS implies that revenue should be

180 entity sells the same good or service to different customers at or near the same time for a broad range of amounts. A selling price is uncertain if an entity has not yet established a price for a good or service, and the good or service has not previously been sold. Any amount allocated under the residual approach should faithfully depict the amount of consideration to which an entity expects to be entitled for the good or service. separate and allocate contract consideration to the various promises in a contract. The elimination of the VSOE requirement for softwarerelated transactions might significantly accelerate the timing of revenue recognition in situations where revenue was previously deferred due to a lack of VSOE of fair value. These changes could also result in the need for significant modifications to the information systems currently used to record revenue. allocated to individual components of a transaction, it does not provide any specific guidance on how that allocation should be determined, except that revenue should be measured at the fair value of the consideration received or receivable. In this context, as it relates to individual elements of a contract, the price regularly charged when an item is sold separately is typically the best evidence of the item s fair value. Other approaches to estimating fair value and allocating the total arrangement consideration to the individual elements may be appropriate, including cost plus a reasonable margin, the residual method, and under rare circumstances, the reverse residual method. Expected impact: The principles in the new standard are similar to current IFRS guidance. However, the new standard includes specific requirements related to the separation, allocation, and recognition of multiple-element transactions that management will need to consider in applying those principles. Post-contract customer support (PCS) As discussed above, entities will allocate transaction price to separate performance obligations based on their relative stand-alone selling prices. PCS is typically a separate performance obligation and can include multiple services. Each service will need to be evaluated to determine whether the service is a separate performance obligation (such as telephone support, unspecified upgrades, and enhancements). Management The VSOE of fair value of PCS is evidenced by its selling price when this element is sold separately. This might include the renewal rate written into the contract, provided the rate and the service term are substantive. The fees for PCS are combined with any licence fees and recognised on a straight-line basis over the PCS term if there is no VSOE of fair value for the PCS. There are also specific limitations on determining VSOE of fair value of PCS in The selling price of a product that includes an identifiable amount of subsequent servicing is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services under the agreement, together with a reasonable profit on those services. Expected impact: The principles in the new standard are similar to current IFRS guidance. However, the new standard includes specific These materials were downloaded from Inform ( under licence.page 180 / 307

181 should estimate the standalone selling price if it does not separately sell a good or service on a stand-alone basis. Software subscriptions will likely have two performance obligations, akin to a licence with PCS: one for the software available today, and another for the right to receive whenand-if available software developed in the future. certain situations. Expected impact: Management will need to estimate the stand-alone selling price of PCS when VSOE was not previously available. This could result in acceleration of revenue recognition for licence deliverables compared to today's guidance, since licence revenue will no longer need to be recognised over the PCS term. Refer to the Intellectual property licences section later in this supplement for discussion related to revenue recognition for the licence deliverables. requirements related to the separation, allocation, and recognition of multiple-element transactions that management will need to consider in applying those principles. Specified upgrades and roadmaps As discussed above, entities will allocate transaction price to separate performance obligations based on their relative stand-alone selling prices. Management should estimate the stand-alone selling price if it does not separately sell a good or service on a stand-alone basis. In a multiple-element software arrangement, VSOE of fair value for all of the elements in the transaction is needed to recognise revenue. VSOE of fair value is generally determined by reference to the price charged to other customers for the same element. Accordingly, it is generally not possible to establish VSOE of fair value for specified future upgrades or products that have not yet been developed since they are not yet being sold and prices do not yet exist. If a roadmap provided to a customer in the context of a current transaction implies a promise to deliver a specified upgrade, revenue is generally deferred until the specified upgrade is delivered. Expected impact: If specified upgrades (including those implied in a roadmap) represent separate performance obligations, management will need to estimate their stand-alone selling prices. This could result Separating the components of a contract might be necessary to reflect the economic substance of an arrangement. IFRS does not define identifiable components of a single transaction. The assessment of components and future obligations is a matter of judgement (regardless of whether the obligation is specifically stated in the contract or to some extent implied). Expected impact: The principles in the new standard are similar to current IFRS guidance. However, the new standard includes specific requirements related to the separation, allocation, and recognition of multiple-element transactions that management will need to consider in applying those principles. These materials were downloaded from Inform ( under licence.page 181 / 307

182 in a different timing of revenue recognition for licence deliverables as compared to today's guidance. Extended payment terms Management should determine if extended payment terms are reflective of a significant financing component. If so, the entity will present the effects of financing (that is, the time value of money) separately from revenue (as interest expense or interest income) in the statement of comprehensive income. Management should consider whether extended payment terms have an impact on the assessment of collectability and defer revenue as necessary. Management should also consider whether the potential for future price concessions affects the estimate of the transaction price (refer to the Variable consideration section below). The software revenue recognition guidance imposes a rebuttable presumption that fees due more than a year after delivery are not fixed or determinable, and thus may be recognised only as payment becomes due. To overcome this presumption, the vendor must have a history of successfully collecting under the original payment terms of comparable arrangements without making concessions. Expected impact: The new standard does not include the concept of presumed deferral of revenue for arrangements with extended payment terms that exists under current US GAAP. Therefore, revenue recognition for deliverables with extended payment terms may be accelerated. Additionally, management will need to assess whether a significant financing component exists when there are extended payment terms. Receivables generated from arrangements with extended payment terms are subject to the financial instruments guidance, and the effect of the time value of money should be reflected, when material. Expected impact: The new standard is similar to current IFRS guidance. Sectors in technology most impacted Software? Cloud Computing Internet Semiconductors Hardware / Equipment Clean-tech Example 4 Sale of licence and PCS separate performance obligations Facts:Software Vendor sells Customer a perpetual software licence and PCS for a period of five years once the software is activated. None of the goods and services are sold on a stand-alone basis, and there is no stated renewal fee for the PCS services. How should Software Vendor account for the transaction? Discussion:Software Vendor should account for the licence and PCS as separate performance These materials were downloaded from Inform ( under licence.page 182 / 307

183 obligations. Software Vendor will need to estimate the stand-alone selling prices because the licence and PCS are not sold separately. No estimation method is prescribed in the new standard. The need to estimate stand-alone selling prices might create practical challenges for some software companies. Variable consideration The transaction price is the consideration a vendor expects to be entitled to in exchange for satisfying its performance obligations in an arrangement. Determining the transaction price is straightforward when the contract price is fixed, but is more complex when the arrangement includes a variable amount of consideration. Consideration that is variable includes, but is not limited to, discounts, rebates, price concessions, refunds, credits, incentives, performance bonuses, and royalties. Management must estimate the consideration it expects to be entitled to in order to determine the transaction price and to allocate consideration to performance obligations. Variable consideration is only included in the estimate of transaction price up to an amount that is highly probable (IFRS) or probable (US GAAP) of not resulting in a significant reversal of cumulative revenue in the future. New standard Current US GAAP Current IFRS An entity needs to determine the transaction price, which is the amount of consideration it expects to be entitled to in exchange for transferring promised goods or services to a customer, including an estimate of variable consideration. The estimate of variable consideration should be based on the expected value or most likely amount approach (whichever is more predictive). Variable consideration included in the transaction price is subject to a constraint. The objective of the constraint is that an entity should recognise revenue as performance obligations are satisfied to the extent that a significant revenue reversal will not occur. An entity will meet this objective if it is highly probable (IFRS) or probable (US GAAP) that there will not be a significant downward adjustment of the cumulative amount of revenue recognised for that performance obligation. Management will need to determine if there is a portion The seller's price must be fixed or determinable for revenue to be recognised. Revenue related to variable consideration generally is not recognised until the uncertainty is resolved. It is not appropriate to recognise revenue based on a probability assessment. Expected impact: The guidance on variable consideration might significantly affect the timing of recognition compared to today. Technology companies often enter into arrangements with variable amounts, such as milestone payments, service level guarantees with penalties, and refund rights, due to their focus on customer adoption of cutting-edge products. Judgement will be needed to determine when variable consideration should be included in the transaction price. Technology companies might recognise revenue earlier than they do currently in many circumstances. These materials were downloaded from Inform ( under licence.page 183 / 307 Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Trade discounts, volume rebates, and other incentives (such as cash settlement discounts) are taken into account in measuring the fair value of the consideration to be received. Revenue related to variable consideration is recognised when it is probable that the economic benefits will flow to the entity and the amount is reliably measurable, assuming all other revenue recognition criteria are met. Expected impact: Variable consideration could be recognised under current IFRS prior to the contingency being resolved if certain criteria are met; however, the guidance on variable consideration under the new standard could affect the timing of recognition compared to today. Technology

184 of the variable consideration (that is, a minimum amount ) that would not result in a significant revenue reversal and should be included in the transaction price. Management will reassess its estimate of the transaction price each reporting period, including any estimated minimum amount of variable consideration it expects to receive. companies often enter into arrangements with variable amounts, such as milestone payments, service level guarantees with penalties, and refund rights, due to their focus on customer adoption of cutting-edge products. Judgement will be needed to determine when variable consideration should be included in the transaction price. An entity that licenses intellectual property to a customer in exchange for consideration that varies based on the customer s subsequent sales or usage of a good or service (a sales- or usage-based royalty) should not recognise revenue for the variable consideration until the uncertainty is resolved (that is, when the customer s subsequent sales or usages occur). Sectors in technology most impacted Software Cloud Internet Semiconductors Hardware / Clean-tech Computing Equipment?????? Example 5 Variable consideration performance bonus Facts:Contract Manufacturer enters into a contract with Customer to build an asset for C100,000. The contract contains a C50,000 performance bonus paid based on timing of completion, with a 10% decrease in the bonus for every week completion extends beyond the agreed-upon completion date. Management estimates a 60% probability of on-time completion, 30% probability of one week late, and 10% probability of two weeks late. The entity has relevant experience with similar contracts. How much of the performance bonus should Contract Manufacturer include in the transaction price? Discussion:Management concludes that the most likely amount method is the most predictive approach for estimating the performance bonus. Management believes that C45,000 (the bonus that will be earned with a one-week delay; the likelihood of not achieving this level of bonus is only 10%) should be included in the transaction price as it is probable that including this amount in the transaction price will not result in a significant revenue reversal. Management should update its estimate at each reporting date. These materials were downloaded from Inform ( under licence.page 184 / 307

185 Sell-through approach The sell-through approach is used for some arrangements with distributors, such that revenue is not recognised until the product is sold to the end customer. This approach might be used because the distributor is thinly capitalised, does not have a high-grade credit rating, or has the ability to return the unsold product, rotate older stock, or receive price concessions (and therefore the risks and rewards of ownership have not transferred), or because the entity cannot reasonably estimate returns or concessions. These arrangements are commonly seen in technology companies. New standard Current US GAAP Current IFRS Revenue is recognised when control of a good or service is transferred to the customer. A customer obtains control of a good or service if it has the ability to direct the use of and receive the benefit from the good or service. Indicators that the customer has obtained control of the good or service include: The entity has a right to payment for the asset. The entity transferred legal title to the asset. The entity transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer provided evidence of acceptance. The sell-through approach is common in arrangements that include dealers or distributors. Revenue is recognised once the risks and rewards of ownership have transferred to the end consumer under the sell-through approach. For example, if the customer is involved with assisting the distributor with sales to end customers, there might be an indication that the risk and rewards of ownership have not transferred upon delivery to the distributor. Additionally, if the amount of returns, refunds, or concessions cannot be reasonably estimated, revenue cannot be recognised until such rights lapse. A contract for the sale of goods normally gives rise to revenue recognition at the time of delivery, when the following conditions are satisfied: The risks and rewards of ownership have transferred. The seller does not retain managerial involvement to the extent normally associated with ownership nor retain effective control. The amount of revenue can be reliably measured. It is probable that the economic benefit will flow to the customer. The costs incurred can be measured reliably. The impact of rights of return is reflected in the estimate of transaction price, as described in a later section. If the above criteria are not met, revenue is recognised once the risks and rewards of ownership have transferred, which may be upon sale to an end consumer. Expected impact: These materials were downloaded from Inform ( under licence.page 185 / 307

186 The effect of the standard on the sell-through approach will depend on the terms of the arrangement and why sell-through accounting was applied historically. The standard requires management to determine when control of the product has transferred to the customer. If the customer or distributor has control of the product, including a right of return at its discretion, control transfers when the product is delivered to the customer or distributor. Any amounts related to expected sales returns or price concessions affect the amount of revenue recognised (that is, the estimate of transaction price), but not when revenue is recognised. The timing of revenue recognition could change (and be accelerated) for some entities compared to current guidance, which is more focused on the transfer of risks and rewards than the transfer of control. The transfer of risks and rewards is an indicator of whether control has transferred under the new standard, but additional indicators will need to be considered. If the entity is able to require the customer or distributor to return the product (that is, it has a call right), control likely has not transferred to the customer or distributor. An entity that is not able to estimate returns, but is able to estimate the maximum amount of returns, should recognise revenue for the amount that it does not expect to be returned at the time of sell-in, provided that control of the products has transferred. Refer to the Rights of return section later in this supplement. Many distributors are thinly capitalised. The entity would still need to assess whether collectability is probable before it recognises revenue. For arrangements where revenue is deferred for one of the above reasons, Management should re-evaluate the appropriateness of the deferral each reporting period based on when the revenue recognition criteria are met, not just upon sell-through of the product to the end customer. Sectors in technology most impacted Software Cloud Internet Semiconductors Hardware / Clean-tech Computing Equipment???? Example 6 Sale of product to a distributor with ongoing involvement Facts:Manufacturer uses a distributor network to supply its product to final customers. The distributor may return unsold product at the end of the contract term. Once the products are sold to the end customer, Manufacturer has no further obligations related to the product and the distributor has no further return rights. Because of the complexity of the products and the varied nature of how they may be incorporated by end users into their final products, Manufacturer supports the distributor with technical sales support, including sending engineers on sales calls with the distributor. These materials were downloaded from Inform ( under licence.page 186 / 307

187 When should Manufacturer recognise revenue? Discussion:Manufacturer should recognise revenue upon transfer of control of the product to the customer. A distributor that takes control of the products and can decide whether to return the goods, has legal title to the goods, and can re-sell or pledge them is the customer of Manufacturer. The technical sales support provided by Manufacturer could be a separate performance obligation. Assuming the sale of the product and the sales support are separate performance obligations, Manufacturer should recognise revenue allocated to the products when control of the goods transfers to the distributor, subject to any anticipated returns, and provided collectability of the consideration from the distributor is probable. Manufacturer should recognise revenue allocated to the support obligation as the support is provided. Example 7 Sale of product to a distributor with price protection clause Facts: Manufacturer sells product into its distribution channel. In the distribution contract, Manufacturer provides price protection by reimbursing its distribution partner for any difference between the price charged to the distributor and the lowest price offered to any customer during the following six months. When should Manufacturer recognise revenue? Discussion: Manufacturer should recognise revenue upon transfer of control of the product to the distributor. The price protection clause creates variable consideration. Manufacturer should estimate the transaction price using either the expected value approach or most likely amount, whichever is more predictive. The estimate of variable consideration is constrained to the amount that is highly probable (IFRS) or probable (US GAAP) of not reversing if estimates of the variable consideration change. Relevant experience with similar arrangements that allow Manufacturer to estimate the transaction price, taking into account the expected effect of the price protection provision, could result in earlier revenue recognition as compared to current practice. Allocation of transaction price Technology companies may provide multiple products or services to their customers as part of a single arrangement. Entities will allocate the transaction price to the separate performance obligations in a contract based on the relative stand-alone selling price of each of the separate performance obligations in the arrangement. New standard Current US GAAP Current IFRS The transaction price is allocated to separate performance obligations based on the relative standalone selling price of the performance obligations in the contract. The stand-alone selling price for items not sold separately should be estimated. A residual approach may be used as a method to estimate the stand-alone selling price in certain situations when the selling price for a good or service is highly variable or uncertain. The consideration in an arrangement is allocated to the elements of a transaction based on the relative standalone selling price. The residual value method cannot be used (except as described above for software companies). Allocation to a delivered item is limited to the consideration that is not contingent on providing an undelivered item or meeting future performance obligations. Expected impact: Allocation These materials were downloaded from Inform ( under licence.page 187 / 307 Consideration is generally allocated to the separate components in the arrangement based on a relative fair value or cost plus a reasonable margin approach. A residual or reverse residual approach could also be used. Expected impact: The basic allocation principle has not changed under the new guidance. However, the required use of relative standalone selling prices will affect those companies that have historically used the residual or reverse residual method, or

188 Some elements of the transaction price, such as variable consideration or discounts, might affect only one performance obligation rather than all performance obligations in the contract. Variable consideration can be allocated to specific performance obligations if certain conditions are met, namely that the terms of the variable consideration relate specifically to the entity s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service). A discount is allocated to a specific performance obligation if the following criteria are met: The entity regularly sells each distinct good or service in the contract on a standalone basis. The entity regularly sells, on a stand-alone basis, a bundle of some of those distinct goods or services at a discount. The discount attributable to the bundle of distinct goods or services is substantially the same as the discount guidance in the new standard might affect the price allocated to the identified performance obligations, and thus the timing of revenue recognition, due to the following: There is no definitive limitation for cash contingent on satisfying a future performance obligation, although such contingent amounts must meet the criteria described above of not being probable of being subject to a significant revenue reversal. An entity can allocate discounts and variable consideration amounts to specific performance obligations if certain conditions are met. applied an approach similar to US GAAP whereby the allocation to a delivered item is limited to the consideration that is not contingent on providing an undelivered item or meeting future performance obligations. Further, allocation guidance in the new standard could affect the price allocated to the identified performance obligations due to the ability to allocate discounts and variable consideration amounts to specific performance obligations if certain conditions are met. These materials were downloaded from Inform ( under licence.page 188 / 307

189 in the contract and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation to which the entire discount in the contract belongs. The transaction price is allocated to separate performance obligations based on the relative standalone selling price of the performance obligations in the contract. The stand-alone selling price for items not sold separately should be estimated. A residual approach may be used as a method to estimate the stand-alone selling price in certain situations when the selling price for a good or service is highly variable or uncertain. Some elements of the transaction price, such as variable consideration or discounts, might affect only one performance obligation rather than all performance obligations in the contract. Variable consideration can be allocated to specific performance obligations if certain conditions are met, namely that the terms of the variable consideration relate specifically to the entitys efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service). The consideration in an arrangement is allocated to the elements of a transaction based on the relative standalone selling price. The residual value method cannot be used (except as described above for software companies). Allocation to a delivered item is limited to the consideration that is not contingent on providing an undelivered item or meeting future performance obligations. Expected impact: Allocation guidance in the new standard might affect the price allocated to the identified performance obligations, and thus the timing of revenue recognition, due to the following: There is no definitive limitation for cash contingent on satisfying a future performance obligation, although such contingent amounts Consideration is generally allocated to the separate components in the arrangement based on a relative fair value or cost plus a reasonable margin approach. A residual or reverse residual approach could also be used. Expected impact: The basic allocation principle has not changed under the new guidance. However, the required use of relative standalone selling prices will affect those companies that have historically used the residual or reverse residual method, or applied an approach similar to US GAAP whereby the allocation to a delivered item is limited to the consideration that is not contingent on providing an undelivered item or meeting future performance obligations. Further, allocation guidance in the new standard could affect the price allocated to the identified performance obligations due to the ability to allocate discounts and variable consideration amounts to specific performance obligations if certain conditions are met. These materials were downloaded from Inform ( under licence.page 189 / 307

190 A discount is allocated to a specific performance obligation if the following criteria are met: The entity regularly sells each distinct good or service in the contract on a standalone basis. The entity regularly sells, on a stand-alone basis, a bundle of some of those distinct goods or services at a discount. The discount attributable to the bundle of distinct goods or services is substantially the same as the discount in the contract and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation to which the entire discount in the contract belongs. must meet the criteria described above of not being probable of being subject to a significant revenue reversal. An entity can allocate discounts and variable consideration amounts to specific performance obligations if certain conditions are met. Sectors in technology most impacted Software Cloud Internet Semi- Hardware / Clean-tech These materials were downloaded from Inform ( under licence.page 190 / 307

191 Computing conductors Equipment?????? Consulting and manufacturing service contracts Many technology companies provide consulting and manufacturing services, including business strategy services, supply-chain management, system implementation, outsourcing services, and control and system reliance. Technology service contracts are typically customer-specific, and revenue recognition is therefore dependent on the facts and circumstances of each arrangement. Accounting for service revenues may change under the new standard, as management must determine whether the performance obligation is satisfied at a point in time or over time. New standard Current US GAAP Current IFRS Revenue is recognised upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time. Over time A performance obligation is satisfied over time if any of the following criteria are met: The customer receives and consumes the benefits of the entity s performance as the entity performs. The entity's performance creates or enhances an asset (workin-process) that the customer controls as the asset is created or enhanced. The entity's performance US GAAP permits the proportional performance method for recognising revenue for service arrangements not within the scope of guidance for construction or certain production-type contracts. However, there is no clear guidance for assessing whether revenue should be recognised over time following the proportional performance method or upon completion of the service. Input measures, with the exception of cost measures, that approximate progression toward completion can be used when output measures do not exist or are not available to an entity without undue cost. Revenue is recognised based on a discernible pattern of benefit. If none exists, a straight-line approach may be appropriate. IFRS requires that service transactions be accounted for by reference to the stage of completion of the transaction. This method is often referred to as the percentage-ofcompletion method. The stage of completion may be determined by a variety of methods (including the cost-tocost method). Revenue may be recognised on a straight-line basis if the services are performed by an indeterminate number of acts over a specified period of time and no other method better represents the stage of completion. Revenue could be deferred in instances where a specific act is much more significant than any other acts to be performed as part of the service. Expected impact: Entities will need to first determine whether a performance obligation is satisfied over time, which may require judgement. We do not expect a significant change in practice for most performance obligations satisfied over time, although management may need to revisit contractual payment terms in some cases to assess whether the right to payment criterion is met. Additionally, there may be certain performance obligations previously recognised at a point in time on final delivery that will These materials were downloaded from Inform ( under licence.page 191 / 307

192 does not create an asset with an alternative use to the entity and the customer does not have control over the asset created, but the entity has a right to payment for performance completed to date. be recognised over time under the new standard. Entities will use the method to measure progress toward satisfaction of a performance obligation that best depicts transfer of control to the customer, which could be an output or an input method. An entity should recognise revenue over time only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation. Point in time An entity will recognise revenue at a point in time (when control transfers) if performance obligations in a contract do not meet the criteria for recognition of revenue over time. Sectors in technology most impacted Software Cloud Internet Semiconductors Hardware / Computing Equipment???? Clean-tech Example 8 Consulting services performance obligation satisfied over time Facts:Computer Consultant enters into a three-month, fixed-price contract to track Customer's software usage to help Customer decide which software packages it should upgrade to in the future. Computer Consultant will share findings on a monthly basis, or more frequently if requested. Computer Consultant will provide a summary report of the findings at the end of three months. Customer will pay Computer Consultant C2,000 per month and Customer can direct Computer Consultant to focus on the usage of any systems it wishes to throughout the contract. How should Computer Consultant account for the transaction? These materials were downloaded from Inform ( under licence.page 192 / 307

193 Discussion:Computer Consultant should recognise revenue over time as it performs the services. Customer receives a benefit from the consulting services as they are performed during the three-month contract; therefore, it is a performance obligation satisfied over time. Example 9 Sale of specialised equipment performance obligation satisfied over time Facts:Contract Manufacturer enters into a six-month, fixed-price contract with Customer for the production of highly customised equipment. Customer does not control the equipment until title transfers at the end of the six-month contract term. Customer will pay Contract Manufacturer a non-refundable progress payment of C10,000 per month for the equipment, which is commensurate with the performance completed to date. How should Contract Manufacturer account for the transaction? Discussion:Contract Manufacturer should recognise revenue over time as it manufactures the equipment. Given the highly customised nature of the equipment, Contract Manufacturer s performance does not create an asset with an alternative use to Contract Manufacturer. Further, Contract Manufacturer has a right to payment from Customer for the performance completed to date, as evidenced by the non-refundable progress payments. The performance obligation therefore meets the criteria for recognition over time. Intellectual property licences A licence is a right to use intellectual property ( IP ) owned by another entity. The licensor often receives fees upfront for licences, and there may also be ongoing royalties. Licence arrangements frequently include other obligations, such as ongoing support, professional services, etc. Licences of IP include, among others: software and technology; media and entertainment rights; franchises; patents; trademarks; and copyrights. Licences can include various features and economic characteristics, which can lead to significant differences in the rights provided by a licence. Licences might also be perpetual or granted for a defined period of time. An entity should first consider the guidance for identifying performance obligations to determine if the licence is distinct from other goods or services in the arrangement. For licences that are not distinct, an entity will combine the licence with other goods and services in the contract and recognise revenue when it satisfies the combined performance obligation. New standard Current US GAAP Current IFRS The nature of rights provided by the licence in some arrangements is to allow access to the entity s evolving IP. A licence that is transferred over time provides a customer access to the entity s IP as it exists throughout the licence period. Licences that are transferred at a point in time provide the customer the right to use the entity s IP as it exists when the licence is granted. The customer must be able to direct the use of and obtain substantially all of the Revenue from licences of intellectual property is recognised in accordance with the substance of the agreement. There is no specific guidance for revenue recognition on licences outside of software licences. Revenue might be recognised on a straight-line basis over the life of the agreement, for example, when a licensee has the right to use the technology Existing revenue guidance requires fees and royalties paid for the use of an entity's assets to be recognised in accordance with the substance of the agreement. This might be on a straight-line basis over the life of the agreement, for example, when a licensee has the right to use certain technology for a specified period of time. It might also be recognised upfront if the substance is similar to a sale. An assignment of rights for a These materials were downloaded from Inform ( under licence.page 193 / 307

194 remaining benefits from the licensed IP to recognise revenue when the licence is granted, although the licensor may periodically provide updates to that IP as a separate performance obligation. There are three criteria used to determine whether a licence provides access to IP and revenue should therefore be recognised over time: The licensor will undertake (either contractually or based on customary business practices) activities that significantly affect the IP to which the customer has rights. The licensor s activities do not otherwise transfer a good or service to the customer as they occur. The rights granted by the licence directly expose the customer to any effects (both positive and negative) of those activities on the IP. If all three of these factors are not met, the licence revenue should be recognised at a point in time. The following factors are not considered in this assessment: for a specified period of time, by analogy to the leasing model. Revenue could also be recognised upfront similar to the model used for software licences in certain situations. Judgement is required to determine the most appropriate treatment. fixed fee or a non-refundable guarantee under a noncancellable contract that permits the licensee to exploit those rights freely when the licensor has no remaining obligations to perform is, in substance, a sale. Judgement is required to determine the most appropriate treatment. Expected impact: The new standard requires revenue to be recognised when the customer obtains control of the rights to use the intellectual property. This is a judgement based on the factors provided in the standard. An entity will need to determine the type of licence it is providing, and this could result in a different timing of revenue recognition compared to today, depending on the entity s current accounting (recognition over time or upfront). These materials were downloaded from Inform ( under licence.page 194 / 307

195 Restrictions of time, geography, or use. Guarantees that the licensor has a valid patent and will defend the licensed IP from infringement. The standard includes an exception for sales- or usage-based royalties from licences of intellectual property. Revenue from those arrangements is not included in the transaction price until the customer s subsequent sales or usages occur. This exception does not apply to an outright sale of IP. Sectors in technology most impacted Software Cloud Internet Semiconductors Equipment Hardware / Clean-tech Computing????? Example 10 Licence to IP with a sales-based royalty Facts: Vendor licenses patented technology in a handheld device for no upfront fee and 1% of future product sales. The licence term is equal to the remaining patent term of 3 years. These materials were downloaded from Inform ( under licence.page 195 / 307

196 Technology in this area is changing rapidly so the possible consideration ranges from C0 to C50,000,000 depending on whether new technology is developed. How should Vendor account for the transaction? Discussion:Royalties from licences of IP are not included in the transaction price until the customer s subsequent sales or usages occur. Royalty revenue is recognised when Vendor is entitled to those amounts, which in the case of a licence with a sales-based royalty is when those future product sales occur. Example 11 Licence to IP with a sales-based royalty and guaranteed minimum Facts: Vendor licenses patented technology in a handheld device for no upfront fee and 1% of future product sales. The licence term is equal to the remaining patent term of 3 years. Technology in this area is changing rapidly so the possible consideration from product sales ranges from C0 to C50,000,000 depending on whether new technology is developed. However, the vendor is entitled to at least C5,000,000 at the end of each year regardless of the actual sales. Management has concluded that the licence transfers at a point in time when the licence period commences. Management has also concluded that it is probable it will collect the consideration to which it is entitled and there are no further obligations remaining after the licence is transferred. How should Vendor account for the transaction? Discussion: As discussed above, Vendor will recognise royalty revenue when the future product sales occur. However, since Vendor is entitled to at least C5,000,000 at the end of each year, this amount of consideration is not variable. Therefore, Vendor should recognise at licence inception the present value of the future minimum payments as revenue. Any consideration from royalties in excess of C5,000,000 in any given year will be recognised as those sales occur. Rights of return Return rights are common in sales involving various technology products. Return rights may also take on various forms, such as product obsolescence protection and trade-in agreements. These rights generally result from the buyer's desire to mitigate the risk related to the products purchased and the seller's desire to promote goodwill with its customers. New standard Current US GAAP Current IFRS Revenue is only recognised for goods that the entity reasonably expects will not be returned and a liability is Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognised for the expected recognised until the return amount of refunds to rights lapse if the entity is customers. The refund liability unable to reasonably estimate is updated for changes in potential returns. expected refunds. An asset and corresponding adjustment to cost of sales is recognised for the right to recover goods from customers on settling the refund liability, with the asset initially measured at the original cost of the goods (that is, the carrying amount in inventory), Expected impact:there could be a change in timing of revenue recognition if an entity defers the entire amount of revenue under current US GAAP due to its inability to estimate returns, especially if there is a cap on returns that would provide a basis to record a minimum amount These materials were downloaded from Inform ( under licence.page 196 / 307 Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognised until the return rights lapse if the entity is unable to reasonably estimate potential returns. Expected impact:there is not expected to be a significant change from current IFRS, except to the extent that an entity needs to gross-up the balance sheet to include the refund obligation and the asset for the right to the returned goods. The asset is assessed for impairment if indicators of

197 less any expected costs to recover those products. The asset is assessed for impairment if indicators of impairment exist. Rights of return are considered a form of variable consideration, as they affect the total amount of fees that a customer will pay. Therefore, revenue recognition follows a similar model as described above for variable consideration, with amounts included in the transaction price if it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of cumulative revenue will not occur. under the variable consideration guidance. The balance sheet will be grossedup to include the refund obligation and the asset for the right to the returned goods. The asset is assessed for impairment if indicators of impairment exist. impairment exist. Sectors in technology most impacted Software Cloud Internet Semiconductors Hardware / Clean-tech Computing Equipment???? Example 12 Sale of product with a return right Facts:Vendor sells and ships 10,000 gaming systems to Customer, a reseller, on the same day. Customer may return the gaming systems to Vendor within 12 months of purchase. Vendor has historically experienced a 10% return rate from Customer. How should Vendor account for the transaction? Discussion: Vendor should not record revenue for the gaming systems that are anticipated to be returned (that is, 1,000 or 10%). Vendor should record a contract liability for 1,000 gaming systems and record an asset for the right to the gaming system assets expected to be returned. The asset should be recorded at the original cost of the gaming systems. Vendor will not derecognise the refund liability and related asset until the refund occurs or the refund right lapses (although Vendor should adjust these amounts as it revises its estimate of returns over time). The asset will need to be assessed for impairment until derecognition. The transaction price for the 9,000 gaming systems that Vendor believes will not be returned is recorded as revenue when control transfers to the customer, assuming Vendor concludes it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of cumulative revenue will not occur. Product warranties It is common for technology companies to provide a product warranty in connection with the sale of a product. The nature of a product warranty can vary significantly. Some warranties provide a customer with assurance that the related product complies with agreed-upon specifications These materials were downloaded from Inform ( under licence.page 197 / 307

198 (assurance-type or standard warranties). Other warranties provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. The new standard draws a distinction between product warranties that the customer has the option to purchase separately (for example, warranties that are negotiated or priced separately) and product warranties that the customer does not have the option to purchase separately. Many of the warranties offered by technology companies could fall in either or both categories. Management will need to exercise judgement when assessing a warranty not sold separately to determine if there is a service component that is a separate performance obligation. New standard Current US GAAP Current IFRS An entity should account for a warranty that the customer has the option to purchase separately as a separate performance obligation that is satisfied over the warranty period. Warranties that a customer can purchase separately are typically similar to extended warranty contracts. Revenue from extended warranties is deferred and recognised over the life of the contract. Warranties that a customer can purchase separately are typically similar to extended warranty contracts. Revenue from extended warranties is deferred and recognised over the life of the contract. A warranty that the customer does not have the option to purchase separately should be accounted for in accordance with existing guidance on product warranties. A warranty, or a part of the warranty, that is not sold separately but that provides the customer with a service in addition to the assurance that product complies with agreedupon specifications, creates a performance obligation for the promised service. An entity that cannot reasonably separate the service component from a standard warranty should account for both together as a single performance obligation. Extended warranties that a customer can purchase separately are accounted for as a separate deliverable in an arrangement. A warranty that is separately priced in a multiple-element arrangement is allocated consideration based on the contractually stated price. Product warranties that provide coverage for latent defects are typically accounted for in accordance with loss contingency guidance, resulting in recognition of an expense and a warranty liability when the good is sold. Expected impact: Similar to existing guidance, warranties sold separately give rise to a separate performance obligation under the new standard and, therefore, revenue is recognised over the warranty period. Warranties that are separately priced may be affected as the arrangement consideration will be allocated on a relative stand-alone selling price basis under the new standard rather than based on the contractual price as under current US GAAP. Warranties that are not sold separately are accounted for in accordance with provisions guidance, resulting in recognition of an expense and a warranty liability when the good is sold. Expected impact: Similar to existing guidance, warranties sold separately give rise to a separate performance obligation under the new standard and, therefore, revenue is recognised over the warranty period. There is not expected to be a significant change in accounting compared to current guidance. These materials were downloaded from Inform ( under licence.page 198 / 307

199 Product warranties that are not sold separately and provide for defects that exist when a product is shipped will result in a cost accrual similar to today s guidance. Sectors in technology most impacted Software Cloud Computing Internet Semiconductors Hardware / Clean-tech Equipment??? Example 13 Product sale with optional warranty Facts: Vendor sells a hard drive, keyboard, monitor, and a 12-month warranty that the customer has the option to purchase. How should Vendor account for the optional warranty? Discussion: The new standard requires Vendor to account for the 12-month optional warranty as a separate performance obligation. A portion of the transaction price is allocated to the warranty based on its relative stand-alone selling price and is recognised as revenue as the warranty obligation is satisfied. Vendor will need to assess the pattern of warranty satisfaction to determine when revenue is recognised (that is, rateable or some other pattern). FOB synthetic destination shipping Products entities often have a customary practice of replacing or crediting lost or damaged shipments, even when sales contracts contain free on board (FOB) shipping point terms, and it is clear that title legally transfers at the time of shipment. The customer is therefore protected from some losses in the same way as if the shipping terms were FOB destination (this is also known as FOB synthetic destination ). Revenue for shipments is typically deferred until the product has been received by the customer under today s guidance, because the risks and rewards of ownership have not been substantively transferred to the customer at the point of shipment. The timing of revenue recognition for these types of arrangements might change under the new standard. New standard Current US GAAP Current IFRS Revenue is recognised upon The risks and rewards of the satisfaction of ownership in the goods need performance obligations, to substantively transfer to the which occurs when control of customer. Revenue is deferred the good or service transfers until the goods have been to the customer. Factors to delivered to the end customer consider in assessing control if the vendor has established a transfer include, but are not practice of covering risk of loss limited to: in transit. The customer has A contract for the sale of goods normally gives rise to revenue recognition at the time of delivery, when the following conditions are satisfied: The risks and rewards of ownership have transferred. The seller These materials were downloaded from Inform ( under licence.page 199 / 307

200 an unconditional obligation to pay. The customer has legal title. The customer has physical possession. The customer has the significant risks and rewards of ownership. The customer has accepted the asset. Situations where an entity transfers a good but retains the risk of loss based on shipping terms could be indicative of an additional performance obligation for the in-transit risk of loss. In this case, revenue should be allocated between the performance obligations (transfer of the good and the in-transit risk of loss). does not retain managerial involvement. The amount of revenue can be reliably measured. It is probable that the economic benefit will flow to the customer. The costs incurred can be measured reliably. Revenue is typically recognised once the goods reach the buyer when there are FOB synthetic destination terms, as risks and rewards of ownership typically transfer at that time. Expected impact: The timing of revenue recognition could change significantly under the new model, as the focus shifts from transfer of risks and rewards to transfer of control of the goods. Management will need to assess whether contract terms or business practices create an additional performance obligation under the new guidance. An example of this could be in-transit risk of loss coverage. Control of the underlying goods transfers and revenue for the product is recognised when the product leaves the seller s location, depending on the contract terms, but there might be a second performance obligation for intransit risk of loss. Management will need to allocate the transaction price to each of the performance obligations, and revenue would be recognised when each performance obligation is satisfied, which might be at different times. Sectors in technology most impacted Software Cloud Computing Internet Semiconductors Hardware / Equipment Clean-tech??? Example 14 FOB synthetic destination Facts: Vendor enters into a contract to sell chipsets to a handset manufacturer. The delivery terms are free on board (FOB) shipping point (the legal title passes to the handset manufacturer when the chipsets are handed over to the carrier). A third-party carrier is used to deliver the chipsets. Vendor has a past business practice of providing replacements to the handset These materials were downloaded from Inform ( under licence.page 200 / 307

201 manufacturer at no additional cost if the chipsets are damaged during transit. The handset manufacturer does not have physical possession of the chipsets during transit, but the handset manufacturer has legal title at shipment and therefore can sell the chipsets to another party. Vendor is also precluded from selling the chipsets to another customer after shipment. How should Vendor account for this arrangement? Discussion: Vendor might conclude that it has two performance obligations: one for fulfilling the order for the chipsets and a second for covering the risk of loss during transit of the chipsets based on its past business practice. Vendor has not satisfied its performance obligation regarding risk of loss coverage at the point of shipment. The transaction price should be allocated to the chipsets and to the service that covers the risk of loss. Revenue for the chipsets is recognised at the time of shipment, as the handset manufacturer has control of the chipsets at that time. Revenue relating to covering the risk of loss is recognised as the goods are transported About PwC s Technology practice PwC s Technology practice provides audit and assurance, business advisory, and tax services to technology entities around the globe in the networking and computers, software & internet, semiconductors and clean technology space. We support our clients through industry restructurings, regulatory transformations, technological advances, and changes in financial reporting and corporate governance requirements. PwC helps organisations and individuals create the value they re looking for. We re a network of firms in 157 countries with more than 184,000 people who are committed to delivering quality in assurance, tax, and advisory services. Questions? PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in Accounting Consulting Services. What s inside: Overview Application of the revenue model Up-front fees received by an asset manager Up-front costs incurred by an asset manager Variable consideration, including management and performance fees Performance fees Retained US GAAP industry guidance Other considerations About PwC s Asset Management practice Revenue from contracts with customers The standard is final A comprehensive look at the new revenue model Asset management industry supplement On 28 May, the IASB and FASB issued their long-awaited converged standard on revenue These materials were downloaded from Inform ( under licence.page 201 / 307

202 recognition. Almost all entities will be affected to some extent by the significant increase in required disclosures. But the changes extend beyond disclosures, and the effect on entities will vary depending on industry and current accounting practices. In depth is a comprehensive analysis of the new revenue standard. This supplement highlights some of the areas that could create the most significant challenges for entities in the asset management industry as they transition to the new standard. Overview Revenue recognition in the asset management industry can be complex, as there are many variations of investment structures aimed at achieving returns or investment income for investors. Under the new revenue standard, the current IFRS and US GAAP industry-specific revenue recognition guidance will be superseded. The impact of the new revenue standard will vary depending on an entity s existing accounting policies. Areas most affected could include, but are not limited to, up-front fees, up-front costs, and performance-based fees. Revenue recognised by an asset manager will now be subject to a constraint. The constraint limits revenue recognised to the amount for which it is highly probable (IFRS) or probable (US GAAP) that a significant reversal in the amount of cumulative revenue recognised will not occur in future periods. As a result, there may be changes in how revenue is recognised in the asset management industry. This supplement focuses on how the standard will impact these arrangements for asset managers. The examples and related discussions are intended to provide areas of focus to assist entities in evaluating the implications of the new standard. Some of the key issues companies will need to address include identifying who their customer is and identifying the separate performance obligations in the arrangement. These topics are explored in more detail below. The new revenue standard is effective for the first interim period within annual reporting periods beginning after 15 December 2016 (for example, 1 January 2017 for an entity with a 31 December year end) under US GAAP. A one-year deferral will apply to non-public entities under US GAAP. The new revenue standard is effective for IFRS reporters for annual reporting periods beginning on or after 1 January An entity has the option to apply the new standard retrospectively to all contracts or use a simplified transition method. Under the simplified transition method, an entity will (i) only apply the standard to existing contracts as of the effective date and to contracts entered into subsequently; and (ii) recognise the cumulative effect of applying the standard to existing contracts in the opening balance of retained earnings on the effective date. An entity will not restate prior periods if it uses the simplified transition method. Additional disclosure will be required for entities that choose to use this method, including the effect on each financial statement line item of applying the guidance in the initial year of application. The new revenue standard does not include a specific scope exception for investment entities as defined by IFRS 10, Consolidated Financial Statements, or investment companies under ASC 946, Financial Services Investment Companies. However, most investment companies will not be significantly impacted because interest income, dividend income, and investment gains are typically generated by transactions outside the scope of the revenue standard. However, investment entities that provide direct investment-related services may be affected. Application of the revenue model The standard contains principles that an entity will apply to determine the amount and timing of revenue recognition. The underlying principle is for an entity to recognise revenue as it transfers These materials were downloaded from Inform ( under licence.page 202 / 307

203 goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. Entities will apply a five-step approach: Step 1: Identify the contract with the customer. Step 2: Identify the separate performance obligations in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to separate performance obligations. Step 5: Recognise revenue when (or as) each performance obligation is satisfied. Key question 1: Who is the customer? The new standard requires an entity to identify the contract with the customer. As part of this step, an entity must determine which party is its customer. This important step has ramifications throughout the revenue model and might significantly affect how the standard is applied. Management will need to apply judgement to determine whether the investor or the fund is the asset manager s customer based on the facts and circumstances. This is an area that may evolve as industry constituents start applying the guidance to typical investment structures. While not determinative, certain factors in isolation may point to the fund or the investor being the customer. Management will need to weigh the different indicators, and make a conclusion based on the overall relationship. A factor that points to the fund being the customer is a fund s ability to enter into contracts with third parties for additional services such as fund accounting or transfer agent activities. Also, there may be numerous investors that the asset manager does not deal with directly. For example, in many registered investment companies, some investors purchase shares through a third-party distributor that holds the shares in an omnibus account along with other investors. An omnibus account is often used by third-party distributors to simplify the subscription and redemption process into a fund. There may be situations where the asset manager does not have visibility into the underlying investors that make up the omnibus account. In other situations, factors may point to the investor as the customer. If the investor is heavily involved in negotiating specific fees, or interacts directly with the manager to set up the fund strategy, this could indicate that the investor is the customer. This may be the case for funds that hold very few investors and thus, the investors have the potential to play a more direct role in the activities or negotiation of the relationship. As noted above, these factors are not determinative, and management will have to consider all facts and circumstances. Determining which entity is the customer is important when it comes to identifying the performance obligation(s), assessing the timing of revenue recognition, and capitalising contract costs. The Boards acknowledged these alternate perspectives during their public deliberations, but ultimately did not formally take a position given the wide variety of arrangements in the asset management industry. In our view, the conclusion should be based on the facts and circumstances of each arrangement and should not be viewed as an accounting policy election. Key question 2: Is there a single performance obligation or multiple performance obligations? Another key question that impacts the timing of revenue recognition is whether there is more than one performance obligation in a contract. There are often several different fees the asset manager is entitled to, such as management fees and distribution fees. The new standard will require a manager to consider whether the services should be viewed as a single performance obligation, or whether some of these services are distinct and should therefore be treated as separate performance obligations. Even though services and related fees may be included in different contracts, they may represent a single performance obligation. The new standard requires an entity to combine These materials were downloaded from Inform ( under licence.page 203 / 307

204 contracts that are entered into at or near the same time and with the same customer and account for them as a single contract if (i) they are negotiated as a package, (ii) the amount of consideration to be paid in one contract depends on the price or performance of the other contract, or (iii) the services in the contracts represent a single performance obligation. Since contracts in the asset management entity are often entered into at the same time with the same counterparty, the contracts would be combined and accounted for as a single contract if, for example, the services performed under the contract represent a single performance obligation. The new standard requires an entity to assess the services promised in a contract with a customer and identify as performance obligations those services that are distinct. A service is distinct if (i) the customer can benefit from the service either on its own or together with other resources that are readily available to the customer and (ii) the service is distinct in the context of the contract. If a service is not distinct, the entity must combine the services until such a point that a bundle of services are viewed as distinct. In some cases, this will result in all services being combined into a single performance obligation. The customer s perspective should be considered when assessing whether a promise gives rise to a performance obligation. Therefore, conclusions regarding who is the customer are likely to impact this determination. This is an area of significant judgement and it is possible that views will evolve in advance of the standard becoming effective. Up-front fees received by an asset manager Asset managers receive or pay various types of fees or costs associated with the distribution of a fund s units. Asset managers may own a broker or distribution entity that distributes the asset managers sponsored products or, in some cases, the asset manager might distribute the sponsored products directly. When distribution is done by the asset manager, or through a distribution entity that is consolidated by the asset manager, the asset manager is entitled to the fees as revenue. This section does not address the accounting in the broker or distribution entity s stand-alone financial statements. Up-front fees are generally associated with front-end loaded distribution. Front-end loaded distribution means that an initial sales fee is paid by the investor to the distribution entity upon subscription to the fund (that is, the investor bears the fee on the front end). This fee compensates the distribution entity with the subscription amount, net of such fee, being contributed to the fund. An asset manager may also need to consider whether revenue needs to be allocated when the asset manager provides distribution services, but does not receive any direct up-front fees. Relevant guidance under the new revenue standard, current US GAAP, and IFRS is summarised below. New revenue standard Current US GAAP Current IFRS The new revenue standard Up-front fees are generally requires the asset manager to recognised as revenue upon assess whether the distribution receipt in accordance with the service is a separate industry guidance in ASC performance obligation apart , which states that, the from other services the asset fees should be recognised manager is providing, or when received. whether it is a supporting activity or component of the overall asset management services. If determined to be a separate performance obligation, the distribution service will generally be These materials were downloaded from Inform ( under licence.page 204 / 307 Up-front fees might be recognised as revenue when received or deferred, depending on the facts and circumstances. Up-front fees are recognised as revenue when received only to the extent that services have been provided and the fees do not relate to future services. The receipt of the initial sales fee does not by itself provide evidence that

205 satisfied upon the investor s subscription and trigger immediate recognition of the revenue, assuming no further commitments remain. Alternatively, if the distribution and asset management services are a single performance obligation, the upfront fee is viewed as an advance payment for future services and is therefore recognised as revenue over time as the overall services are performed. An asset manager may also need to consider whether revenue needs to be allocated when the asset manager provides a distribution service that is a separate performance obligation, but does not receive any direct up-front fees. all services associated with that fee have been provided or that the fair value of any up-front services is equal to the initial sales fee received. If the fee is linked to other services or obligations (for example, as evidenced by a fee that is not at fair value for those individual services or the pricing is only understood with reference to services to be performed in the future), the revenue that corresponds with this part of the fee is deferred and recognised as those services are performed. In these cases, the initial sales fees are typically deferred and spread over the period that the investor is expected to remain with the fund being managed. Potential impact: This analysis will be impacted by who is determined to be the customer. Up-front fees will either be deferred or recognised immediately, depending on whether or not the relationship with the customer indicates that there is a distinct service provided upfront. In some cases, the relationship with the customer may indicate that it is difficult to distinguish between distribution services and asset management services. Accordingly, the distribution service would likely not be a separate performance obligation. It would instead be grouped with other activities and deferred over the period that the investor is expected to remain invested in the fund. Entities will need to consider the specific facts and circumstances of each arrangement, given the various These materials were downloaded from Inform ( under licence.page 205 / 307

206 fee arrangements and corresponding responsibilities of the distributor. These differences can have a significant impact on identifying who the customer is, as well as the nature of the performance obligations. Example 1: Fees received by an asset manager (through its consolidated broker-dealer) for mutual fund share distribution services Facts: An investor pays a front-end fee to an asset manager upon investing into the fund. All of the distribution services are provided by the asset manager or one of its consolidated subsidiaries acting in a broker-dealer capacity. The service is therefore part of the asset manager s consolidated financial statements. How should the asset manager account for the front-end fee? Discussion: The accounting for the front-end fee will depend on conclusions regarding who the asset manager s customer is in this arrangement and whether there are multiple performance obligations. If the relationship between the customer and the asset manager is viewed as a single performance obligation (that is, managing an investor s money and the related activities), the distribution activity may be one of several different activities that are part of this contractual relationship with the customer. Accordingly, the manager would recognise the front-end load fee over the estimated period that the investor is expected to remain in the fund. If the relationship with the customer is considered to include multiple performance obligations (for example, finding investors, managing assets, and entering into contracts with third parties), the distribution service may qualify as a distinct service and a separate performance obligation. The up-front fee received for the distribution service would be recognised immediately, as long as the service is complete and the manager (distributor) does not have any ongoing distribution responsibility tied to the fee. Up-front costs incurred by an asset manager Asset managers may incur a cost to pay third parties for successfully introducing investors to a fund. Such costs are sometimes called sales commissions or placement fees. Often, such fees are not refundable if the investor leaves the fund. The fund usually is not required to reimburse or compensate the asset manager for the up-front cost. New revenue standard Current US GAAP Current IFRS An asset manager will In accordance with industry Fixed costs paid that are recognise as an asset the practice, sales commissions incremental and directly incremental costs of obtaining (that is, fixed costs) paid to a attributable to securing an a contract if it expects to third-party distributor are investment contract (for recover those costs. The generally recognised as an example, sales commissions or incremental costs of obtaining asset and amortised over the placement fees) are capitalised a contract are those costs that expected period that the if they can be identified the asset manager would not investor will remain in the separately, measured reliably, have incurred if the contract fund, which can range from a and it is probable that they will had not been obtained (for few months to several years. be recovered. An incremental example, a sales The asset is reviewed for any cost is one that would not have commission). potential impairment. been incurred if the entity had not secured the investment An asset recognised in Sales commissions and management contract. The These materials were downloaded from Inform ( under licence.page 206 / 307

207 accordance with the above is amortised on a systematic basis consistent with the pattern of transfer of the services to which the asset relates. A practical expedient is available allowing incremental costs to be expensed when incurred if the amortisation period would be one year or less. An impairment loss is recognised to the extent that the carrying amount of the capitalised asset exceeds the net amount of consideration to which the entity expects to be entitled in exchange for the services to which the asset relates, less the remaining costs that relate directly to providing those services. The asset manager will be required to consider whether such amounts are costs to obtain a contract with a customer. This may require judgement and may depend, in certain cases, on whether the fund or investor is viewed as the customer in the arrangement. Potential impact: If the costs incurred are considered to be a cost of obtaining a new contract, an asset is recognised if expected to be recovered and amortised on a systematic basis consistent with the pattern of transfer of the services to the customer. In the asset management industry, it may be more common to view these as costs to obtain a contract if the investor is viewed as the customer. If the cost incurred does not relate to a new contract with a customer, the cost would likely be recognised as an expense when incurred. If the asset placement fees are generally expensed as incurred, assuming they are not subject to the industry guidance that is currently included in ASC (moved to ASC ). Additional information regarding this retained guidance is included in more detail in the section titled, Retained US GAAP industry guidance. These materials were downloaded from Inform ( under licence.page 207 / 307 asset is amortised as the asset manager recognises the related revenue. If the carrying value of the capitalised asset exceeds the recoverable amount, the asset is impaired and an impairment loss is recognised.

208 manager views the fund as the customer, it is less likely that the fees would be viewed as a cost to obtain a new contract. This determination should be based on the facts and circumstances of the arrangement. Example 2: Placement fees Facts: An asset manager is required to pay a fee to a third-party marketer if it successfully introduces an investor into a fund that the asset manager manages. The fund is not required to reimburse or compensate the asset manager for the up-front cost. The asset manager receives a base management fee from the fund. For purposes of this example, assume the costs are outside the scope of the retained cost guidance for mutual fund distribution costs for US GAAP preparers, which is discussed in more detail in a subsequent example. How should the asset manager account for the placement fee that it pays to the third party? Discussion: The accounting for the placement fee will depend on conclusions regarding who the asset manager s customer is in this arrangement. If the relationship with the customer indicates that the service the third party performs is not associated with obtaining a new contract (because the asset manager already has a management contract with the fund), the cost will likely be expensed as incurred. On the other hand, if the relationship with the customer indicates that the placement fee is a cost to acquire a contract with a customer and such costs are expected to be recovered, the costs should be capitalised and amortised over the period benefited by the contract. The asset manager could elect to expense such costs if the amortisation period would be one year or less. Variable consideration, including management and performance fees Under the new revenue standard, the transaction price is the consideration the asset manager expects to be entitled to in exchange for satisfying its performance obligations. One of the primary performance obligations in the asset management industry is the delivery of asset management services. This performance obligation is satisfied over time as asset management services are delivered. Management must determine the amount of the transaction price at contract inception and at each reporting date. The entity will recognise revenue as the performance obligation is satisfied. If the amount that the asset manager expects to be entitled to is variable, the variable consideration included in the transaction price is limited to the amount for which it is highly probable (IFRS) or probable (US GAAP) that a significant reversal of the amount of cumulative revenue recognised will not occur when the uncertainty is resolved. In making this assessment, an entity should consider both the likelihood and the magnitude of the revenue reversal. Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, (i) the amount of consideration is highly susceptible to factors outside the entity s influence (for example, market volatility), (ii) the uncertainty about the amount of consideration is not expected to be resolved for a long period of time, and (iii) the contract has a large number and broad range of possible consideration amounts. Management will need to determine if there is a portion of the variable consideration (that is, some minimum amount) that should be included in the transaction price, even if the entire estimate of variable consideration is not included due to the constraint. Management s estimate of the transaction price will be reassessed each reporting period, including any estimated These materials were downloaded from Inform ( under licence.page 208 / 307

209 minimum amount of variable consideration. Management fees are often based on net assets under management, while performance fees are usually based on profits generated from the underlying investments held by the funds subject to certain thresholds (for example, hurdle rate, high watermark, or internal rate of return). As such, management fees and performance fees are forms of variable consideration. The table below summarises the new guidance for management and performance fees, and compares the new standard to current IFRS and US GAAP guidance. New revenue standard Current US GAAP Current IFRS Management fees: Management fees: Management fees: A fixed percentage assetbased management fee is considered a type of variable consideration that is subject to the constraint. For management fees, an asset manager will update its estimate of the variable consideration each reporting period. Because the management fee is calculated based on net assets under management, any uncertainty related to the variable consideration will be resolved as of the end of each reporting period. The asset manager will attribute the revenue from management fees to the services provided during the period, because the fee relates specifically to the entity s efforts to transfer the services for that period. Potential impact: In general, there is no expected impact for management fees that are based on current assets under management and are not subject to clawback. Performance fees: Return-based performance fees are also considered variable consideration. The asset manager should recognise revenue only if, after an assessment of the facts and circumstances, it is highly probable (IFRS) or probable (US GAAP) that the amount of A fixed percentage asset-based management fee is earned periodically for providing asset management services. These fees are generally recognised as revenue each period in accordance with the terms of the asset management contract. Performance fees: Performance fees based on a formula that are tied to returns subject to performance targets (for example, high watermark) may be recognised using one of two methods. Under Method 1, performance fees are recognised in the periods during which the related services are performed and all the contingencies have been resolved. For hedge fund managers, this typically occurs at the end of the year or upon the occurrence of the crystallisation event. For private equity fund managers, this typically occurs upon termination of the fund or when distributions from a fund exceed the clawback portion of the historic performance fees distributions. Under Method 2, performance fees are recognised as revenue at the amount that would be due under the contract at any point in time as if the contract was terminated at that date (otherwise known as the A fixed percentage assetbased management fee is earned periodically for providing asset management services. These fees are generally recognised as revenue each period in accordance with the terms of the asset management contract. Performance fees: These materials were downloaded from Inform ( under licence.page 209 / 307 Performance fees that are tied to returns subject to performance targets (for example, high watermark) may be recognised using one of two methods. Under the first approach, the asset manager recognises revenue based on the performance up to the measurement date, including an estimate of performance fees ultimately to be received. In this case, the asset manager s estimates are reassessed at each measurement date. Under the second approach, non-contingent and contingent fees are analysed separately. Performance fees, being contingent amounts of revenue, are recognised as the services are performed but only when the fee becomes reliably measurable, which is often at the end of the performance period, once the outcome is known.

210 the variable consideration would not result in a significant reversal of cumulative revenue recognised when the uncertainty is resolved. This new threshold for recognising variable consideration is often referred to as the constraint that must be met in order to recognise the variable consideration as revenue. Accordingly, performance fees that have a broad range of possible outcomes and are highly susceptible to market volatility will often not be included in the transaction price until the uncertainty is resolved or almost resolved. Management will need to determine if there is a portion of the variable consideration (that is, some minimum amount) that should be included in the transaction price, even if the entire estimate of variable consideration is not included due to the constraint. Management s estimate of the transaction price will be reassessed each reporting period, including any estimated minimum amount of variable consideration. Potential impact: Application of the new guidance may result in significant changes for entities that record revenue under the first approach under IFRS, or Method 2 under US GAAP, given that the new guidance requires a higher degree of certainty regarding the amount of the performance fee before revenue is recognised. On the other hand, those applying the second approach under IFRS, or Method 1 under US GAAP, will need to consider whether a minimum amount of consideration should be recognised at an earlier point in time. hypothetical liquidation method ). As a result, there is a possibility that revenue recognised for fees earned by exceeding performance targets early in the measurement period could be reversed due to missing performance targets later in the measurement period. These materials were downloaded from Inform ( under licence.page 210 / 307

211 Example 3: Management fees Facts: An asset manager has a management contract with a fund to provide investment management services. The management fee is 1% of the fund s net assets and is paid quarterly with no potential for clawback. How should the asset manager account for the management fee? Discussion: We believe that, in many circumstances, revenue from periodic management fees based on assets under management will be recognised in a manner that is consistent with current practice under both IFRS and US GAAP. In this case, the asset manager will be able to record revenue each quarter because the services have been utilised by the fund. Additionally, the uncertainty is resolved as of the end of the reporting period and the fee is not subject to any potential reversal. Performance fees The contractual measurement period for performance fees for hedge fund managers and traditional fund managers is often the end of the fiscal year, and in some cases even longer. Therefore, in many cases, the performance fees will be constrained until this contractual measurement period is completed. This means that the revenue will generally not be recognised in full in the interim periods (for example, at the end of each quarter). However, management will need to determine if there is a portion (a minimum amount) of the variable consideration that should be recognised prior to the end of the contractual measurement period. The full amount of the fee will likely be recognised as of the end of the contractual measurement period when the asset manager becomes entitled to an amount that is fixed. In certain cases, the full amount of the fee will be recognised upon a crystallisation event (for example, redemptions) because the amount becomes fixed at that time and is no longer subject to reversal. Asset managers of funds with a finite life (for example, ten years) often receive performance fees that are subject to clawback on a cumulative basis, based on the performance of the fund over its life. In that case, if a fund makes a distribution to the manager, it is possible the manager will have to return the cash distribution if the fund underperforms in the future. Therefore, periodic cash receipt from a fund as a result of its current performance does not necessarily indicate that the entity is able to recognise the amount as revenue. For funds with a finite life, asset managers will need to evaluate the appropriate time when the performance fees (or a portion thereof) are not constrained by the variable consideration guidance. This may be before the end of the fund s life. If a fund were to assess performance fees in relation to a high watermark, there may be a point in time in the later years of a fund s life cycle where the fee is no longer constrained, given the fund s cumulative performance in relation to remaining assets. For example, there could be a point in time where a fund that holds a limited number of remaining investments could sustain total losses on those investments and still exceed the high watermark. Therefore, a portion of the performance fee may no longer be constrained and should be recognised as revenue. Example 4: Performance fees Facts: An asset manager has a management contract with a fund to provide investment management services. In addition to a base management fee, the manager is entitled to a performance fee that is equal to 20% of profits generated by the investments in the fund. The management agreement states that the performance fee shall be calculated, and crystallised, on the last business day of the calendar year. How should the asset manager account for the performance fee? These materials were downloaded from Inform ( under licence.page 211 / 307

212 Discussion: The contractual measurement period is based on the terms of the contract, which, in this case, is as of the last business day of the year. To the extent that the performance fees are subject to the constraint on variable consideration, revenue will not be recognised in the interim periods (for example, at the end of each quarter). This determination will require judgement. Applying the guidance in the new revenue standard will often result in delayed revenue recognition as compared to current practice under the first approach under IFRS or Method 2 under US GAAP. Retained US GAAP industry guidance Under US GAAP, certain guidance on up-front costs in ASC (now moved to ASC ) has been retained. This does not apply to IFRS preparers, because this guidance did not exist in previous IFRS and the IASB did not include it in the new revenue standard. The fee and cost arrangements can be very complex in the asset management industry, especially for registered investment companies (RICs or mutual funds) in the States. RICs often have multiple share classes that possess unique fees, both in amount and timing. The initial introduction of the investor to the fund may either be performed by the manager (or one of its related parties) or by a separate third-party distributor, which can create additional complexities. The illustration below provides a high-level overview of basic fee arrangements to help provide context to the following guidance and example. This illustration is overly simplified, and it is important for companies to consider their own facts and circumstances. Example 5 addresses the accounting for costs paid to third parties for their services in the sales of registered mutual fund shares. This arrangement is depicted by the up-front commission paid to the third-party distributor in the illustration below. The retained US GAAP guidance for up-front costs incurred is described in the table below: New revenue standard Current US GAAP Current IFRS Up-front costs incurred for Refer to the guidance retained No such industry guidance These materials were downloaded from Inform ( under licence.page 212 / 307