Making sense of a complex world

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1 MIAG Issue: 2 Media Industry Accounting group February 2012 Making sense of a complex world Revenue recognition for media companies This paper explores some of the main implications for media companies of the revenue recognition ED re-exposed in November 2011.

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3 Contents Page Introduction to MIAG 04 Revenue recognition re-exposed ED implications for media companies 05 Background 07 Licences and rights to use 08 Variable consideration 12 Accounting for multiple performance obligations 14 Options to acquire additional goods or services 18 Accounting for return rights 20 Contract costs 22 Player points / Promotion programmes 24 Conclusion 26 Publications / further reading 27 Contacts 28

4 Introduction to MIAG PwC s Media Industry Accounting Group (MIAG) brings together our specialist media knowledge from across our worldwide network. Our aim is to help our clients by addressing and resolving emerging accounting issues which affect the entertainment & media sector. With more than 3,575 industrydedicated professionals, PwC s global entertainment & media practice has depth and breadth of experience across key industry sectors including: television, film, advertising, publishing, music, internet, video games, radio, sports, business information, amusement parks, casino gaming and more. And just as significantly, we have aligned our media practice around the issues and challenges that are of utmost importance to our clients in these sectors. One such challenge is the increasing complexity of accounting for transactions and financial reporting of results complexity which is driven not just by rapidly changing business models but also by imminent changes to the world of IFRS accounting. Through MIAG, we aim to work together with the entertainment & media industry to address and resolve emerging accounting issues affecting this dynamic sector, through publications such as this one, as well as conferences and events to facilitate discussions with your peers. I would encourage you to contact us with your thoughts and suggestions about future topics of debate for the MIAG forum, and very much look forward to our ongoing conversations. With best regards Marcel Fenez PwC Hong Kong Global Leader, PwC Entertainment & Media Marcel Fenez 4 MIAG Issue: 2

5 Revenue recognition re-exposed ED implications for media companies Revenue is hopefully! the largest item in the income statement so changes to revenue recognition are invariably important. Our second MIAG paper explores some of the main implications for media companies of the revenue recognition Exposure Draft (ED) re-exposed in November The IASB and FASB (the boards ) initiated a joint project in 2002 to develop a common revenue standard for IFRS and US GAAP. The original exposure draft was issued in June 2010, to which the boards received nearly 1,000 comment letters. The boards then released an updated exposure draft on 14 November 2011 with comments requested by 13 March It is unclear when a final standard will be issued; however, the boards have indicated that it will have an effective date of no earlier than The proposed model requires a five-step approach. Management will first identify the contract(s) with the customer and separate performance obligations therein. Management will then estimate and allocate the transaction price to each separate performance obligation. Revenue is recognised for each performance obligation when the seller transfers control of the relevant good or service to the customer. The proposed standard can result in significant shifts in how revenue is recognised. This paper explores some of the effects for media companies, focusing on areas such as licences, returns, contract costs, and software and advertising arrangements. In some cases, the effects could be considerable, requiring management to perform a comprehensive review of contracts, business practices and accounting policies; and also of the IT systems used to capture the support data. As always, planning ahead can prevent painful surprises. We hope you find this paper useful and welcome your feedback. Best wishes Jeff Feiereisen PwC US PwC Media Industry Accounting Group Jeff Feiereisen Issue: 2 MIAG 5

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7 Background PwC s Media Industry Accounting Group (MIAG) is a premier forum for discussing and resolving emerging accounting issues which affect the entertainment and media sector visit our dedicated website: Overview The entertainment and media industry includes various subsectors, such as filmed entertainment, television, music, video games, publishing, radio, internet and gaming. Each subsector has unique product and service offerings. In certain subsectors, industry-specific revenue recognition guidance exists under US GAAP. IFRS does not have industryspecific guidance. The following issues common to the entertainment and media industry may be significantly affected by the proposed revenue recognition standard: licences, returns, contract costs and software and advertising arrangements. This practical guide is based on the exposure draft, Revenue from contracts with customers, which was issued on 14 November These proposals are subject to change until a final standard is issued. The examples reflect the potential effect based on the proposed standard; any conclusions are subject to further interpretation and assessment based on the final standard. We have also provided a high-level summary of key changes from the original exposure draft issued on 24 June 2010 (the 2010 exposure draft ). References to the proposed model or proposed standard refer to the exposure draft issued in November 2011 unless otherwise indicated. For a more comprehensive description of the proposed standard, refer to PwC s Practical guide Revenue from contracts with customers or visit or The proposed standard can result in significant shifts in revenue recognition Issue: 2 MIAG 7

8 Licences and rights to use Many media companies license intellectual property to third parties. Such licences might include the right to exploit a motion picture in various markets and territories, or the right to exploit a character to be used in a video game or other consumer product. Under the 2010 exposure draft, revenue recognition for the licence of intellectual property was dependent on whether the licence was exclusive or non exclusive. Proposed model (November 2011) Current US GAAP Current IFRS A licence is a right to use, but not own, intellectual property that is granted by a seller to the customer. The recognition of revenue for the licence of intellectual property is a performance obligation that is satisfied when the customer obtains control of those rights. Control of rights to use intellectual property cannot be transferred prior to the beginning of the licence period. Sale of episodic television series in syndication Current guidance requires the following conditions to be met before revenue is recognised: Persuasive evidence of an arrangement exists; The film content is complete, has been delivered or is available for immediate delivery; The licence period has begun, and the customer can begin its exploitation, exhibition or sale; The arrangement fee is fixed or determinable; and Collection of the arrangement fee is reasonably assured. Delivery may occur on a daily or weekly basis, even though all of the episodes are complete and ready for delivery, in order to allow for the insertion of advertisements into the filmed product. A contractual provision allowing the producer to insert its national advertising spots is not considered a provision that would preclude revenue recognition. The net present value of the entire syndication contract is recognised as revenue upon commencement of the licence term if the criteria above are met. IFRS does not contain any industryspecific accounting for media companies. In general, revenue should not be recognised under licensing agreements until performance under the contract 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 licensor 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 up-front: Fixed fee or non-refundable guarantee; The contract is non-cancellable; Customer is able to exploit the rights freely; and The vendor has no remaining performance obligations. Licences and right to use motion pictures It is common in certain countries for a producer to license a film to a counterparty in several markets, such as theatrical, home video and television. Such contracts typically have predefined dates when the title can be exploited in each of the markets. Each contract also typically specifies an overall minimum guaranteed payment that may be paid up-front or allocated to the various components by market. For amounts allocated to the various markets, revenue is generally recognised as each market becomes available. When receipt of a licence fee or royalty is contingent on the occurrence of a future event, revenue is recognised only when it is probable that the fee or royalty will be received, which is normally when the event has occurred. 8 MIAG Issue: 2

9 Revenue for a licence of intellectual property will be recognised when the customer obtains control of the content and can use it Proposed model (November 2011) Current US GAAP Current IFRS Although current practice is mixed, generally the licence fee is allocated to the various markets (for example, theatrical, home video and television) on a relative fair value basis, and revenue is recognised when the market is contractually available for exploitation. Licences to use a record master or music copyright The licence of a record master or music copyright may be considered an outright sale if the licensor has signed a noncancellable contract, has agreed to a fixed fee, has delivered the rights (as well as the recording) to the licensee, and has no remaining significant obligations to furnish music or records (that is, contracted recordings have been transferred). The earnings process is complete and the licensing fee is recorded as revenue if the licence is, in substance, an outright sale and if collectibility is reasonably assured. If the licensor is unable to determine the amount of the licence fee earned (that is, the licence allows for a continued amount of additional music to be provided), the consideration received should be recognised as revenue equally over the remaining performance period, which is generally the period covered by the licence agreement. Impact Careful consideration will need to need to be given to what represents the performance obligation (for example, an episode or the series) and when control is transferred for each obligation (that is, at inception or at some later point in the contract term). The timing of revenue recognition for the licence of an episodic television series, filmed entertainment and music is not anticipated to be significantly impacted by the proposed standard. That is, in many cases, revenue for a licence of intellectual property (IP) will be recognised when the customer obtains control of the content and is able to exploit the IP. The licensor should estimate any variable consideration in determining the transaction price. Revenue is recognised when the seller is reasonably assured of being entitled to the fee, which could affect the timing of revenue recognition. The licensor is not reasonably assured to be entitled to an amount of consideration from a licence arrangement that is dependent on the customer s subsequent sales until those future sales occur. Issue: 2 MIAG 9

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11 Key changes from the 2010 exposure draft The distinction made in the 2010 exposure draft between non-exclusive and exclusive licences was eliminated during deliberations based on feedback received by the boards. Respondents believed that revenue should be recognised when the performance obligation is satisfied regardless of whether the licence is exclusive or non-exclusive. Revenue is recognised for a licence that is a separate performance obligation when the customer controls and can use the intellectual property of the seller. Example 1 Sale of episodic television series in syndication Facts: Studio XYZ licenses 100 of its completed episodes of an episodic television series to a cable channel for a four-year period commencing 1 January 20XX on an exclusive basis in that country. The cable channel pays an annual fee of 4 million in equal monthly instalments and is contractually obligated to air this programme each weeknight. Additionally, Studio XYZ has the right to insert two 30-second advertising spots into each airing of the show. How should Studio XYZ account for the licence fee? Discussion: Today, the net present value of the payment stream is recognised as revenue when the series is available for exploitation by the cable channel. Consistent with current practice, revenue will be recognised under the proposed standard once the licensee obtains control of the property (that is, the content is available for exploitation). The impact of the time value of money will need to be assessed if the contract includes a significant financing component as the content is delivered at the beginning of the licence period while the payments are made throughout the contract term. Example 2 Licences and rights to use motion pictures Film A Studio Z Other Customers Film A (10 years) Cash ( ) Royalty Customer Y i) Minimum guarantee 10m 4m theatrical availability 4m home video release 2m TV availability Facts: Studio Z licences certain international windows for Film A to a customer for a 10-year period in return for 10 million, to be paid as follows: 4 million on theatrical availability; 4 million on the date six months after the theatrical release date (which is also the home video availability date) and 2 million one year after the theatrical release date (which is also the television availability date). The arrangement prohibits Studio Z from licensing Film A to other parties in the same markets and territory during the original licence term. How should Studio Z account for the licence fee? Discussion: Studio Z will need to determine if one licence (that is, a 10-year licence for multiple windows theatrical, home video and television) is granted to the customer or if three distinct licences are granted (that is, a licence for each release theatrical, home video and television). Assuming Studio Z determines that each release is a distinct licence, the transaction price of 10 million would be allocated to each licence based on their relative standalone selling prices. Revenue allocated to each distinct licence would be recognised once the licensee obtains control of the content and is able to exploit it under the terms of the agreement. Example 3 Non-exclusive licence of record master or music copyright Facts: Record Label enters into a non-exclusive licence agreement with a retailer. The licence allows the retailer to use Song X for two years in advertisements produced by the retailer. The terms of the agreement do not require Record Label to provide the retailer with any additional content or deliverables. How should Record Label account for the licence agreement? Discussion: Record Label has no further performance obligations under the terms of the agreement, so revenue is recognised once control of the licence was obtained by the retailer, as that is when the retailer can exploit Song X under the agreement. The distinction in the 2010 exposure draft between exclusive and non-exclusive is eliminated in the new proposed model Issue: 2 MIAG 11

12 Variable consideration Many arrangements in the entertainment and media sector include minimum guaranteed payments, with additional potential variable consideration in the form of royalties or other incremental payments. Management will need to assess variable consideration in determining the transaction price to be allocated to the performance obligations. Proposed model (November 2011) Current US GAAP Current IFRS The transaction price is the amount of consideration that a seller expects to be entitled to in exchange for transferring goods or services to the customer, excluding amounts collected on behalf of third parties (for example, sales taxes). The transaction price, including any variable amounts, should be estimated at contract inception and at each reporting period. Any variable consideration should be estimated using either the expected value (based on the sum of probability-weighted amounts) or the most likely amount, whichever is most predictive of the amount to which the seller will be entitled. International sales of films for a minimum guarantee and potential variable upside consideration A licensee may commit to pay a minimum non-refundable licence fee up-front in a licensing arrangement. The licensor may also include a provision stipulating that they are entitled to a percentage of the licensee s revenues once the variable rate exceeds the amount of the fixed minimum guarantee. The revenue associated with a nonrefundable fixed minimum guarantee is allocated to each market being licensed on a relative selling price basis and is generally recognised once the licence for that market is available for the licensee, presuming all of the revenue recognition conditions have been met. Any amounts to be paid by a licensee in excess of a fixed non-refundable minimum guarantee payment are typically recognised by the licensor once the variable fee exceeds the total minimum guarantee (that is, the contingency is resolved). Minimum guarantees associated with a record master or music copyright Minimum guarantees received in advance by the licensor are initially reported as a liability and are recognised as revenue as the licence fee is earned. If the amount of the licence fee earned cannot be determined, the guarantee is recognised as revenue on a straight-line basis over the licence term. Revenue is recognised for a licence fee or royalty that is contingent on the occurrence of a future event only when the revenue is reliably measurable and it is probable that the fee or royalty 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. Impact The licensor should estimate the amount of consideration it will be entitled to, including any variable consideration, in determining the transaction price. The recognition of consideration that includes variable amounts is recognised when control passes to the customer if the seller is reasonably assured to be entitled to the variable amount. The requirement to estimate variable consideration will require licensors to make subjective estimates of the transaction price that may not have been made in the past. Revenue recognition that is currently restricted to only the non-contingent amount could change significantly under the proposed model, depending on the nature of the contingency. However, the proposed standard is not expected to significantly affect the timing of revenue recognition for licences that involve variable amounts based on sales-based royalties (for example, revenue based on a percentage of product sold by a digital service provider or another third party). These amounts generally will not be recognised prior to the uncertainty being resolved. 12 MIAG Issue: 2

13 Key change from the 2010 exposure draft The original exposure draft allowed for revenue recognition of variable amounts without constraint provided the transaction price can be reasonably estimated. The recognition of variable amounts will now be limited to the amount to which the entity is reasonably assured to be entitled. The transaction price will still include an estimate of variable consideration for allocation purposes, similar to the 2010 exposure draft. Previously, this estimate was based on a probability-weighted amount. The boards received feedback that a probability-weighted approach would not be appropriate in some circumstances; as a result, it changed the requirement to the more predictive of either a probability-weighted or most likely amount. Example 4 Licences and rights to use motion pictures Film A Studio Z Other Customers Film A (10 years) Cash ( ) Royalty Customer Y i) Minimum guarantee 10m 4m theatrical availability 4m home video release 2m TV availability ii) 10% of customer Y sales Facts: Studio Z enters into a contract with a customer to license certain international windows for Film A for a 10-year period in return for a minimum guarantee of 10 million plus a royalty of 10% of revenues once total revenues from exploitation of Film A exceed 100 million. The guarantee is to be paid as follows: 4 million on theatrical availability, 4 million on the date six months after the theatrical release date (which is also the home video availability date) and 2 million one year after the theatrical release date (which is also the television availability date). The arrangement prohibits Studio Z from licensing Film A to other parties in the same markets and territory during the original licence term. How should Studio Z account for the royalty revenue? Discussion: Variable consideration is generally recognised once the amount is earned. Variable consideration should be included in the transaction price under the proposed standard and allocated to the separate performance obligations based on the relative estimated selling price approach, but only recognised once the seller is reasonably assured of being entitled to it. Studio Z does not recognise the revenues associated with the royalty until they are received, as the amount is dependent on sales derived by the customer. That is, Studio Z is not reasonably assured to be entitled to the royalty revenues until the subsequent sales occur by the licensee. Example 5 Non-exclusive licence of record master or music copyright Facts: Record Label enters into an agreement with a digital service provider to license the full catalogue of Record Label s music content for five years. Under the terms of the agreement, the digital service provider will be entitled to current content plus any new music content added to the catalogue. The terms of the licence include a nonrefundable minimum guarantee payable at contract inception plus a portion of future sales (that is, downloads) in excess of the minimum guarantee. How should Record Label account for licence fees? Discussion: Currently, up-front revenue recognition is precluded, as the label is required to provide new content throughout the term of the licence agreement. Under the proposed standard, the timing of revenue recognition may change. Record Label will need to identify all performance obligations in the contract and allocate total estimated consideration to the content currently available and the content anticipated to be available during the term. Redemption rates ( breakage ) will need to be considered and estimated for revenue allocated to future content. Consideration associated with the sales-based royalty will be recognised once Record Label is reasonably assured of being entitled to the amount, which will be when the future sales occur. The requirement to estimate variable consideration will require licensors to make subjective estimates of the transaction price Issue: 2 MIAG 13

14 Accounting for multiple performance obligations Performance obligations are defined as a promise to deliver goods or perform services. Determining when to separately account for these performance obligations under the proposed standard is a key determination and could require a significant amount of judgement. Management will need to determine whether performance obligations in a contract need to be accounted for separately from other performance obligations in the contract. The separation criteria might result in more performance obligations being identified than under current practice. Proposed model (November 2011) Current US GAAP Current IFRS The model requires performance obligations that are distinct to be accounted for separately (assuming the performance obligations are delivered at different times). A good or service is distinct and should be accounted for separately if the seller regularly sells the good or service separately or the customer can benefit from the good or service, either on its own or together with other resources readily available to the customer. The transaction price is allocated between the separate performance obligations based on relative estimated selling prices. 14 MIAG Issue: 2 Additional functionality included in software products, including video games Certain software products (for example, console video games) provide additional functionality (such as online services and multi-player functionality) in addition to the core software. Management should assess whether the services are incidental to the overall product and are therefore an inconsequential deliverable in such arrangements. When the additional functionality is inconsequential, revenue is generally recognised at delivery (that is, upon the transfer of the risk and rewards to the customer). Revenue is generally recognised proportionately over the estimated service period when the functionality is more than inconsequential. This is because vendor-specific objective evidence (VSOE) of fair value does not typically exist for the online functionality, as it is not sold separately from the game. Impact: Video game developers will need to determine whether the video game and the additional services should be accounted for as separate performance obligations under the proposed standard. Management will need to determine whether the game and additional services are distinct performance obligations. If they are distinct, the transaction price will be allocated to the separate performance obligations. Because the video game is typically delivered at a single point in time while the services are delivered over a future service period, the timing of revenue recognition might be affected. A seller should apply the revenue recognition criteria to each separately identifiable component of a single 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. When elements in a single contract are accounted for separately, fair value should be used in allocating the transaction price to the separate elements. Companies are not precluded from separating elements in a single contract if the elements are not sold separately. Impact: Multiple-element arrangements accounted for under IFRS might be affected because the performance obligations will need to be accounted for separately if they are distinct. The relative estimated selling price approach will be applied in allocating the transaction price to the separate performance obligations rather than the relative fair value allocation.

15 Proposed model Current US GAAP Current IFRS Software as a service in the video game industry Revenue from sales of software products playable on hosted servers on a subscription-only basis is generally recognised proportionately over the estimated service periods, beginning when the software is activated and delivery of the related services begins. Impact: Contracts with only one performance obligation might not be significantly affected by the proposed standard. However, video game publishers will need to determine whether there are multiple performance obligations in a contract that provides for use of games through a hosted subscription model. Advertising arrangements Advertising arrangements often include more than one type of advertising placement, ranging from print to TV to internet banners and impressions. Current guidance requires deliverables in contracts to be accounted for separately if each deliverable has stand-alone value. Impact: Advertisers will need to assess whether advertising contracts include more than one performance obligation. The separation criteria in the proposed standard might be less restrictive than current US GAAP, which could result in more performance obligations being accounted for separately and affect the timing of revenue recognition. This change in the separation criteria might impact some entities more than others, depending on the approach currently applied. More performance obligations may be identified than under current practice Issue: 2 MIAG 15

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17 Key changes from the 2010 exposure draft The basic principle of accounting for separate performance obligations has not changed from the 2010 exposure draft. The boards have provided additional guidance on when a bundle of goods or services could result in a single performance obligation, in an effort to better reflect the economics of certain long-term contracts The boards also revised the guidance for determining whether a performance obligation is distinct. The concept of a distinct profit margin was removed. The focus is now on whether the good or service is sold separately by the seller or whether the good can be used with other resources readily available to the customer. Example 6 Online functionality included in software products Facts: Company A develops and sells video games. The video games include additional services that enhance the user experience by allowing multiplayer game formats and other online services. Company A does not sell the additional services on a standalone basis. It has historically accounted for the sale of a video game with additional services that enhance the user experience together, recognising revenue for both the game and the services over the service period. How should Company A account for the sale of the video game and services? Discussion: Company A will need to determine if the video game and the additional services are distinct and should be accounted for separately under the proposed standard. If the game and additional services are not distinct because the game cannot be used without the online services, the contract should be accounted for as one performance obligation, consistent with current practice. Revenue would be recognised over the service period. Example 7 Advertising arrangements Facts: Advertiser B provides multiple forms of internet advertising to customers, including impression-based advertising and activity-based advertising, both in standalone and in bundled arrangements. Advertiser B enters into a contract with Customer X to provide three advertising campaigns. Advertiser B will provide 100,000 click-throughs, two banners and 50,000 impressions during the term of the contract. The total arrangement consideration is 100,000. Advertiser B has established a rate card that is to be used as a starting point in negotiating pricing. However, discounts are commonly granted to customers and the range of pricing is not consistent. Advertiser B has historically accounted for the deliverables as one unit of account when sold on a combined basis due to the inconsistency in pricing of the individual elements. How should Advertiser B account for the advertising revenue? Discussion: Advertiser B will need to consider whether the advertising campaigns included in the contract should be accounted for separately. Assuming the campaigns are delivered at different times, Advertiser B will need to assess whether the advertising campaigns are distinct performance obligations. Because the advertising spots are sold separately and are not dependent on one another, they are distinct; the transaction price is therefore allocated to each of the three campaigns based on their relative estimated selling prices. Revenue is recognised as the advertising spots are delivered during the campaign. The transaction price is allocated based on relative estimated selling prices Issue: 2 MIAG 17

18 Options to acquire additional goods or services A seller may grant a customer the option to acquire additional goods or services. Often such options provide a discount on subsequent purchases. It is not uncommon in filmed entertainment to include the option to renew a series for incremental seasons. Licensors will need to determine if that promise gives rise to a material right to the customer in order to determine the appropriate accounting for the option. Proposed model (November 2011) Current US GAAP Current IFRS An option to acquire additional goods or services gives rise to a separate performance obligation in the contract 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 separate performance obligations based on the estimated standalone selling price of the option as, in effect, the customer is paying for future goods or services to be received. Revenue is recognised for the option when it expires or when the 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 option can only be exercised because of entering into the previous contract. Such an option is considered a marketing offer. Impact Options to renew a series for incremental seasons Producers of episodic television series often enter into licensing agreements that allow the licensee to license additional seasons. The option to acquire additional seasons is usually considered to be at fair value and no allocation of consideration is made to the option. 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 of a single transaction in order to reflect the substance of the transaction. If a seller grants to its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, the seller accounts for that option as a separate component of the arrangement; it therefore allocates consideration between the initial good or service provided and the option. Revenue will need to be allocated to the option and deferred until delivery of the second item or when the right expires if the producer determines that the pricing for the incremental seasons provide a material right to the licensee. Renewal contracts may provide a customer with a material right to acquire future goods or services (based on the terms of the original contract) that are similar to the original goods or services. The transaction price in such options may need to be allocated to the optional goods or services based on the expected goods or services to be provided and the expected consideration to be received. 18 MIAG Issue: 2

19 Key changes from the 2010 exposure draft No significant changes from the 2010 exposure draft. Example 8 Options to renew a series for incremental seasons Facts: Studio X produces an episodic television series and licenses 13 episodes to be produced in season one to Network Z for a licence fee of 1.5 million per episode. The arrangement also includes an option whereby Network Z, at its sole discretion, can require Studio X to produce seasons two and three for a licence fee of 2 million and 2.5 million per episode, respectively. How should Studio X account for the option? Discussion: Studio X recognises revenue of 1.5 million, as it delivers each episode to Network Z under existing US GAAP. No specific accounting consideration is given to the existence of the option to acquire subsequent seasons. These options will be exercised only if Network Z believes that the episodic series has some reasonable level of consumer acceptance. Under IFRS, Network Z allocates a portion of the consideration to the option and defers this amount until the right is exercised or expires. In evaluating these options under the proposed standard, Studio X determines that the option provides a material right to the licensee because fixed pricing establishes significant upside for Network Z if the series becomes a hit (that is, if a new licence was entered into, the pricing would be materially different). The estimated transaction price for the licence of the episodic television series, therefore, would include the amount of consideration Studio X expects to be entitled to from the exercise of the option to license the two additional seasons. The total transaction price would then be allocated to the performance obligations, including the future obligations related to seasons two and three. Issue 2 MIAG 19

20 Accounting for 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; some are implied during the sales process. These rights take many forms and are driven generally by the buyer s desire to mitigate technological risk or the risk that the product will not sell, and the seller s desire to promote goodwill with its customers. Proposed model (November 2011) Current US GAAP Current IFRS Revenue should not be recognised for Sales of digital or physical music goods expected to be returned; rather, a Revenue is recognised for sales of liability should be recognised for the physical music products (for example, expected amount of refunds to compact discs) once the product is customers. The refund liability should be updated for changes in expected available for release (that is, at the public refunds. An asset and corresponding release date), which is typically after the adjustment to cost of sales should be recognised for the right to recover goods from customers on settling the refund liability, with the asset initially measured product has been shipped by the producer to the retailer. The amount of revenue recognised is affected by the estimated returns that are expected. at the original cost of the goods (that is, the former carrying amount in inventory). Impact Revenue is recognised for the sale of digital music once the consumer downloads the song or album. The sale of digital music does not include the right of return. Revenue is typically recognised at the gross amount (in full), with a provision being recorded against revenue 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. Accounting for returns will be largely unchanged under the proposed standard. However, the balance sheet will be grossed up to include the refund obligation as a liability (not a contra-asset) and to include an asset for the right to the returned goods. The timing of revenue recognition might be affected for the sale of physical product, as recognition currently occurs once the retailer has the ability to sell the product to consumers (at the public release date). Recognition is predicated on the transfer of control of the performance obligation under the proposed standard. The seller should consider whether the customer has the ability to direct the use of, and benefit from, the merchandise (that is, the customer has an obligation to pay, has physical possession, legal title, the significant risks and rewards of ownership and evidence of acceptance of the merchandise) in determining whether control has transferred. Revenue recognition could occur earlier than current practice if control transfers once the customer obtains the physical product (rather than at the public release date). The accounting for the sale of digital music is not anticipated to change under the proposed standard, as revenue recognition will occur once the consumer obtains control of the download. 20 MIAG Issue: 2

21 Key changes from the 2010 exposure draft No significant changes from the 2010 exposure draft. Example 9 Sale of physical product by a publisher Facts: A publisher sells 100 copies of Book A for 10 each. The books cost 2 to produce and include a return right. The retailer takes physical possession of the books and is contractually obliged to pay for the inventory once the books are received. The publisher determined that the estimated sales returns associated with this transaction are 30%, based on historical sales patterns. The publisher estimates that the costs of recovering the products will be immaterial and expects the returned products can be resold at a profit. Discussion: Once control transfers to the retailer, 700 of revenue ( 10 x 70 products (100 less the 30% expected returns) and cost of sales of 140 ( 2 x 70 products) is recognised. An asset of 60 (30% of product cost) is established for the anticipated sales returns, while a liability of 300 (30% of product sale price) is established for the refund obligation (rather than recording an allowance against accounts receivable). The impact of the anticipated returns on royalties and 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 the estimated returns would require an adjustment to the corresponding asset and liability. The timing of revenue recognition might be affected for the sale of physical product Issue 2 MIAG 21

22 Contract costs Existing US GAAP currently includes a substantial amount of guidance relating to the capitalisation of costs specific to many of the entertainment and media subsectors, both relating to pre-contract costs and costs to fulfil a contract. Companies will need to consider whether the accounting for contract costs will be affected by the proposed standard, as the proposed standard also includes contract cost guidance. Proposed model (November 2011) Current US GAAP Current IFRS Costs incurred in fulfilling a contract Filmed entertainment that are within the scope of other The production of motion pictures and episodic standards (for example, inventory, television series require a significant up-front intangibles, fixed assets) should be investment. Projects to produce content can accounted for in accordance with those other standards. If costs include significant development stage incurred in fulfilling a contract are expenditures, including those to acquire not within the scope of other intellectual property such as film rights to books or standards, the seller will recognise an asset only if the costs relate directly to a contract, relate to future activity and are expected to be recovered. Costs capitalised under the proposed standard will original screenplays. Currently, such development costs are typically capitalised and included in the film asset balance. Such costs would typically be written-off if the project is not green-lit, within three years of the date of initial cost capitalisation. be amortised as control of the goods or services to which the asset relates is transferred to the customer. All costs related to satisfied performance obligations and costs related to inefficiencies are expensed as incurred. Incremental costs of obtaining a contract are capitalised if they are expected to be recovered. If the amortisation period of the incremental costs is less than one year, such costs may be expensed as incurred as a practical expedient. Impact: The accounting for costs to produce an episodic television series and film costs (that is, capitalisation and amortisation) including direct negatives, overall deal costs, rights to film properties, costs incurred for significant changes, as well as the allocations of production overhead and capitalisation of interest is not anticipated to be significantly affected by the proposed standard. Video games Software development costs typically include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products. Software development costs are capitalised once technological feasibility of a product is established and such costs are deemed recoverable. Technological feasibility encompasses both technical design and game design documentation, or the completed and tested product design and working model. Costs incurred to establish the technological feasibility of a computer software product to be sold, leased or otherwise marketed are expensed as incurred as research and development costs. Costs related to support or maintenance are expensed at the earlier of when the related revenue is recognised and when the costs are incurred. Impact: The accounting for software development costs is not anticipated to change under the proposed standard. IFRS does not include specific guidance for recognising costs in relation to selling goods or rendering services. However, for the rendering of services, the percentage-of-completion method generally should be applied to the accounting for revenue and associated expenses. It might be appropriate to capitalise costs if the seller can recognise an asset under the inventory, fixed asset or intangible asset standards, and if the costs meet the definition of an asset. Costs such as training costs are typically not capitalised because they do not meet the definition of an asset. However, certain initiation or pre-contract costs may be capitalised when such costs can be separately identified, reliably measured and it is probable that the contract will be obtained. Further, such costs can only be capitalised if they meet the definition of inventory, property, plant and equipment, intangible assets or an asset within the framework. Certain costs associated with filmed entertainment could be capitalised and would be accounted for as an intangible asset. Costs not capitalisable are expensed as incurred. Any costs capitalisable are subject to the existing guidance on impairments. Impact: The accounting for contract costs is not expected to be significantly affected. 22 MIAG Issue: 2

23 The proposed standard also includes contract cost guidance Proposed model Current US GAAP Current IFRS Music Advance royalties paid to artists are capitalised if the past performance and expected future performance of the artist provide a sound basis for estimating that the amount of the advance that will be recoverable from future royalties earned by the artist. Similarly, the record master costs incurred by the record company are capitalised if the past performance and expected future performance of the artist provide a sound basis for estimating that the cost will be recoverable from future sales. Impact: The accounting for advance royalties and record master costs is not anticipated to change under the proposed standard as existing cost guidance is not expected to be superseded by the proposed standard. Publishing Pre-publication costs represent direct costs incurred in the development of a book or other media and include costs for the associated delivery method when such media is digital. Costs that are typically capitalised include both internal and external costs but are limited to those that are directly attributable to a specific title. Impact: The accounting for many pre-publication costs is expected to remain consistent with current practice. Cable television Many costs incurred in the cable television business are capitalised, including franchise application fees, certain direct selling costs, subscriber-related costs and costs incurred for the construction of a cable television plant. Direct selling costs include commissions, salaries, and targeted advertising; subscriberrelated costs include costs incurred to obtain and retain customers. Construction costs that may be capitalised include: Direct costs incurred during the pre-maturity period for the construction of the cable television plant including materials, direct labour and construction overhead. Programming costs incurred in anticipation of servicing a fully operating system and that will not vary significantly regardless of the number of subscribers are capitalised. Initial subscriber installation costs, including material, labour and overhead costs related to the hook-up of subscribers are capitalised. Impact: The accounting for costs incurred by cable operators is not anticipated to be impacted by the proposed standard. Key changes from the 2010 exposure draft Costs to obtain a contract were to be expensed as incurred under the 2010 exposure draft. The boards received feedback that certain costs to obtain a contract may meet the definition of an asset and should be capitalised. The guidance was therefore revised to require recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered, and if the contract period is greater than one year. The boards clarified that costs to fulfil a contract are in the scope of the revenue guidance only if they are not addressed by other standards. Costs of abnormal amounts of wasted materials, labour or other resources that were not considered in the price of the contract should be expensed when incurred. Issue 2 MIAG 23

24 Player points / Promotion programmes Gaming companies provide various forms of incentive programmes. Such incentives may be based on past levels of play or to induce future play. They may be discretionary (that is, based on past levels of play or to induce future play) or non-discretionary (that is, earned by the customer based on past gaming activity). Proposed model (November 2011) Current US GAAP Current IFRS An option to acquire additional goods or Non-discretionary incentive programmes services gives rise to a separate There are two models used to account performance obligation in the contract if for non-discretionary incentive the option provides a material right to the programmes in the gaming industry: customer that the customer would not receive without entering into that (i) a deferred revenue model; and (ii) an contract. Management will need to immediate revenue/cost accrual model. estimate the transaction price to be allocated to the separate performance obligations based on the estimated standalone selling price of the option. The customer is paying for the future goods or services to be received when customer award credits (incentives) are issued in conjunction with a current sale. Management recognises revenue for the option when it expires or when these future goods or services are transferred to the customer. A portion of the revenue from the original transaction is allocated to the incentive, based on a relative fair value allocation under the deferred revenue model. The amount allocated to the incentive is recognised when the incentive is redeemed or expires. Revenue is recognised under the immediate revenue/cost accrual model at the time of play and an accrual is made for the expected costs of satisfying the incentive. Discretionary incentive programmes Discretionary incentives are typically considered part of the normal marketing activities of the gaming entity. Discretionary incentives may be offered in advance of the related gaming revenue or after the related gaming revenue. The incentive is recognised as an expense when the related revenue is recognised in either case because either (i) the revenue is recognised after the incentive is offered or (ii) the offer is made immediately after the revenue is recognised by the vendor. Loyalty programmes are accounted for as multiple-element arrangements. Revenue is allocated between the initial service 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 the other buyers absent entering into the initial purchase transaction and expected forfeitures. The fair value allocated to the incentive is deferred and recognised when the awards are redeemed or expire. 24 MIAG Issue: 2