Revenue Recognition

Revenue Recognition Current Developments Developed and presented by Samuel A. Monastra, CPA

Revenue Recognition • SAMUEL A. MONASTRA, CPA Mr. Monastra is a Director with McGladrey, LLP. He has extensive experience with publicly held companies and large privately held companies. Industry focus: manufacturing, life sciences & technology, financial services, and public sector. Mr. Monastra served in executive roles with National CPA firms, and as a member of the Editorial Board of the Pennsylvania CPA Journal. He has also been a frequent speaker for numerous State CPA Societies, the Institute of Internal Auditors, and the Institute of Management Accountants on financial reporting topics. Mr. Monastra has a focus on financial reporting with a particular emphasis on Revenue Recognition, IASB/FASB Convergence, IFRS, Business Combinations, Asset Impairments, and Fair Value.

Revenue Recognition • Revenue is usually one of the largest items on a company’s financial statements. Accordingly, both in substance and form, it may be one of the most important components to present fairly, in all material respects, in accordance with the applicable financial reporting framework. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are continuing to jointly define revenue recognition for what is truly becoming a worldwide economy

Revenue Recognition • FASB - rules based • IASB – principles based The FASB based the rules for revenue recognition on a document housed within the SEC reporting guidelines: SEC Staff Accounting Bulletin No. 104 (SAB 104) Additional guidance is based upon SFAS No. 48 “Revenue Recognition When the Right of Return Exists” and AICPA Statement of Position No.97-2 “Software Revenue Recognition”

Revenue Recognition Today, Revenue Recognition Codification 605 Sub-section • 10 Overall • 15 Products • 20 Services • 25 Multiple Element Arrangements • 28 Milestone Method • 30 Rights to Use • 35 Construction & Production Contracts • 40 Gains & Losses • 45 Principal Agent Considerations • 50 Customer Payments & Incentives

Revenue Recognition Here are the basics: • Revenue must be earned or realized before financial statement recognition • EARNED when an entity has substantially performed what is necessary to be entitled to the benefits of the revenue • REALIZED when assets received or receivable are readily convertible into known amounts of cash

Revenue Recognition • Recognize revenue when the transaction is consummated (revenue is both earned and realized) The four “bedrock” principles: persuasive evidence of an arrangement price is fixed or determinable ability to pay delivery or performance has occurred

Revenue Recognition • Also consider: • Right of return/ refund policy • Parties must be independent of each other • Must be an arms length transaction • Seller has no further obligations • Not a consignment

Revenue Recognition • Areas of concern include: • “bill and hold” transactions • Channel stuffing • Early/ delayed shipments • Segregation of goods • Ignore customer acceptance provisions • Side agreements

Revenue Recognition • Areas of concern include: • Related party transactions • Sales cut-offs • Unusual terms – not typical for the company or industry • Fraud

Revenue Recognition • Areas of concern include with rights of return: • Allowed to return unsold items • Inability to estimate or significant increase in inventory in distribution channel • New products and newness of products • Shift in product demand or technology • Long return periods • Goods become obsolete, used up, fulfill original purpose, break, etc.

Revenue Recognition • Present authoritative sources: • Accounting Standards Codification • Topic 600 -- Revenues • Topic 985 -- Software

Revenue Recognition • Industries with specific revenue recognition revenue recognition rules and exceptions include: Section Industry • 905 Agriculture • 908 Airlines • 910 Contractors- Construction • 912 Contractors- Federal Government • 915 Development Stage Companies • 920 Entertainment- Broadcasters • 922 Entertainment- Cable TV • 924 Entertainment- Casinos • 926 Entertainment- Film • 928 Entertainment- Music

Revenue Recognition • Revenue recognition – sale of breeding livestock The gain or loss on the sale of breeding livestock, regardless of whether purchased or raised, is included in gross revenue. This treatment recognizes the fact that the sale of breeding livestock, either as cull animals or as seed stock, is a normal, planned, and ongoing part of the business.

Revenue Recognition • Theatres: Recognize revenue at the time of exhibition unless nonrefundable guarantees are paid by the exhibitor (which may happen with a“hot” film when the exhibitor bears little risk), in which case revenue is recognized upon execution of the license agreement, provided all of the following criteria are met. The license fee is known and collected or the cost can be reasonably determined and collected. The licensee has accepted the film in accordance with the license agreement. The film is available for its first showing.

Revenue Recognition • Casinos: Casino revenue is reported on the accrual basis. Revenue recognized and reported by a casino is generally defined as a win from gaming activities, that is, the difference between gaming wins and losses, not the total amount wagered. Base jackpots shall be charged to revenue ratably over the period of play expected to precede payout; however, if immaterial, they shall be charged to revenue when established. Any portion of the base jackpot not charged to revenue when the jackpot is paid shall be charged to revenue at that time.

Revenue Recognition • Industries with specific revenue recognition revenue recognition rules and exceptions include: Section Industry • 932 Extractive Industries- Oil & Gas • 940 Financial Services- Brokers & Dealers • 942 Financial Services- Depository & Lending • 944 Financial Services- Insurance • 946 Financial Services- Investment Companies • 948 Financial Services- Mortgage Banking • 952 Franchisors • 954 Health Care Entities • 958 Not-for-Profit Entities • 970 Real Estate- General

Revenue Recognition • Franchise Revenue • Revenues include retail sales at Company restaurants and franchise and property revenues. Franchise revenues include royalties, and initial and renewal franchise fees. Property revenues include rental income from operating lease rentals and earned income on direct financing leases on property leased or subleased to franchisees. Retail sales at Company restaurants are recognized at the point of sale and royalties from franchisees are based on a percentage of retail sales reported by franchisees. Royalties are recognized when collectibility is reasonably assured. Initial franchise fees are recognized as revenue when the related restaurant begins operations. A franchisee may pay a renewal franchise fee and renew its franchise for an additional term. Renewal franchise fees are recognized as revenue upon receipt of the non-refundable fee and execution of a new franchise agreement. In accordance with SFAS No. 45, “Accounting for Franchise Fee Revenue,” the cost recovery accounting method is used to recognize revenues for franchisees for whom collectibility is not reasonably assured. Rental income on operating lease rentals and earned income on direct financing leases are recognized when collectibility is reasonably assured.

Revenue Recognition • Industries with specific revenue recognition revenue recognition rules and exceptions include: Section Industry • 972 Real Estate-Common Interest Realty Associations • 974 Real Estate-REIT’s • 976 Real Estate-Retail Land • 978 Real Estate-Time Sharing • 980 Regulated Operations • 985 Software

Revenue Recognition • Software Industry • Nuances • Sales cycle • Development costs • Multiple deliverables • Mode of delivery

Revenue Recognition The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRSs that would:Remove inconsistencies and weaknesses in existing revenue requirements. • Provide a more robust framework for addressing revenue issues. • Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets. • Provide more useful information to users of financial statements through improved disclosure requirements. • Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. • To meet those objectives, the FASB and the IASB are proposing amendments to the FASB Accounting Standards Codification® and to IFRSs, respectively.

Revenue Recognition FASB vs. IASB • FASB - rules based • IASB – principles based • What does it mean to have a rules based system? • What Does it mean to have a principles based system?

Revenue Recognition FASB vs. IASB Why the different systems? Culture Geography Legal system

Revenue Recognition FASB vs. IASB • What Does “International Convergence of Accounting Standards” Mean? • The phrase international convergence of accounting standards refers to both a goal and the path taken to reach it. • The FASB believes that the ultimate goal of convergence is a single set of high-quality, international accounting standards that companies worldwide would use for both domestic and cross-border financial reporting. • Today, the path toward that goal is the collaborative efforts of the FASB and the International Accounting Standards Board (IASB) to both improve U.S. generally accepted accounting principles (U. S. GAAP) and International Financial Reporting Standards (IFRS) and eliminate the differences between them.

Revenue Recognition FASB vs. IASB • The FASB believes that there is demand for international convergence, driven by investors’ desire for high-quality, internationally comparable financial information that is useful for decision-making in our increasingly global capital markets. • The FASB and the IASB have been working together toward convergence since 2002. The two Boards have described what convergence means and their tactics to achieve it in two different documents—the Norwalk Agreement issued in 2002 and the Memorandum of Understanding (MOU) between the IASB and the FASB, originally issued in 2006 and updated in 2008.

Revenue Recognition FASB vs. IASB The main way the FASB and IASB collaborate is through joint projects to develop common standards. The FASB issues those standards as U.S. GAAP and the IASB issues them as IFRS; over time, the two sets of standards are expected to both improve in quality and become increasingly similar if not the same.

Revenue Recognition FASB vs. IASB Over 140 countries use IFRS Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Cuba, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, India, Ireland, Israel, Italy, Japan, Mexico, Russia, Spain, Switzerland, Taiwan, United Kingdom, to name a few.

Revenue Recognition FASB vs. IASB • The future path of IFRS in the U.S. remains unclear. While over 170 foreign companies whose stocks trade in the U.S. are able to file their financial statements in IFRS with the SEC without reconciling them with U.S. GAAP, thanks to a rule change in 2007, it is unlikely at this point that the SEC will agree to allow U.S. companies to do the same this year.

Revenue Recognition FASB vs. IASB • The long, arduous process of harmonizing IFRS and U.S. GAAP is continuing for now, but other countries are pushing the IASB to adopt a more multilateral approach, with greater involvement by Asian countries like China and India. U.S presence on the Monitoring Board may even be diminished, as another regulator from the Americas could take the place of the SEC. The priorities of the IASB are likely to shift toward other countries’ wish lists for standards in areas such as foreign currency exchange and agriculture, and those priorities are not likely to match up with U.S. demands.

Revenue Recognition FASB vs. IASB Simplification Transparency Consistency

Revenue Recognition FASB vs. IASB Overview • Preliminary views document issued in December 2008 • Exposure draft issued in June 2010 • Revised exposure draft issued in November 2011 with comments due March 13, 2012 • Final standard expected in late 2012 / early 2013

Revenue Recognition FASB vs. IASB Scope • Applicable to all industries and entities • Specific contracts with customers outside of scope: financial instruments, guaranties (other than warranties), insurance, leases, certain non-monetary transactions • Contracts with performance obligations in multiple standards • Recognition and measurement principles also applicable to sales of non-financial assets that are not classified as revenue

Revenue Recognition FASB vs. IASB Core principle: • Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition • Revised proposed revenue model Five Steps • Identify contract with the customer • Identify separate performance obligations • Determine the price • Allocate the price to the performance obligations • Recognize revenue as performance obligations are satisfied

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 1) Identify contract with the customer • Enforceable agreement between parties • Can be written, oral or implied • Combination: required for contracts entered into at or near the same time if certain criteria are met • Modifications are treated separately if separate performance obligation is added and the consideration is consistent with the standalone price. Otherwise combine with remaining goods and services

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 2) Identify separate performance obligations • Promise in a contract to transfer a good or service • Account for separately if distinct because either of the following criteria are met: good or service is regularly sold separately or customer can benefit from good or service on its own or together with other readily available services • However, bundle of promised goods or services accounted for as one performance obligation if both of the following criteria are met: highly interrelated and require significant integration service and significantly modified or customized to fulfill contract

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 3) Determine the transaction price • Amount of consideration to which an entity expects to be entitled from a customer • Variable consideration – estimate based on probability-weighted or most likely amount. • Time value of money only affects transaction price if significant financing component exists can ignore if time between payment and transfer of services is one year or less

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 3) Determine the transaction price • Noncash consideration measure at fair value or by reference to standalone selling price of related goods or services • Consideration payable to a customer reduction of transaction price unless in exchange for a distinct good or service • Collectibility not considered in transaction price record uncollectible amounts adjacent to revenue

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 4) Allocate the transaction price • Generally based on relative standalone selling prices of separate performance obligations • Standalone selling price observable selling price when sold separately otherwise, estimate based on cost plus margin, adjusted market assessment, or residual technique if highly variable or uncertain • Subsequent changes in the transaction price are allocated on a relative standalone selling price unless certain criteria are met

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 5) Recognize revenue • Recognize revenue as performance obligations are satisfied based on transfer of control • Determine if satisfied (and revenue recognized) over time, based on whether an entity’s performance: creates or enhances an asset the customer controls or does not create an asset with an alternative use and one of the following criteria is met: customer receives a benefit as entity performs, another entity would not need to re-perform work completed to date, vendor has right –to-payment for performance to date select method of progress toward completion (output or input)

Revenue Recognition FASB vs. IASB • FASB and IASB Convergence Project- Revenue Recognition Five Steps 5) Recognize revenue • If prior criteria not met, then satisfied at a point in time • Recognize revenue when customer obtains control based on the following indicators: entity has right to payment entity has transferred legal possession customer has legal title and risks and rewards of ownership customer has accepted goods or services • Recognize amount allocated to performance obligation except for certain variable consideration, which is limited to reasonably assured amount based on: experience with similar performance obligations, whether that experience is predictive of outcome

Revenue Recognition Other revenue issues Onerous performance obligations • Only applicable to performance obligations satisfied over a period greater than one year • Recognize liability if allocated transaction price is less than lower of: direct costs to satisfy performance obligation, or amount to be paid to exit the performance obligation

Revenue Recognition Other revenue issues Onerous performance obligations • Direct costs include: Direct labor and materials Allocated costs directly related to contract Costs explicitly charged to the customer Other costs incurred only because contract entered into

Revenue Recognition Other revenue issues Contract Costs • Capitalize direct costs of fulfilling a contract or anticipated contract if those costs: Generate or enhance a resource that will be used to satisfy performance obligations in the future (e.g. set-up costs) and Are expected to be recovered • Capitalize incremental costs to obtain contract if expected to be recovered • Practical expedient to expense costs as incurred if amortization period would have been one year or less

Revenue Recognition Other revenue issues Warranties • Customer option to purchase separately: Separate performance obligation recognized over time (warranty service) • No customer option to purchase separately and warranty does not provide an additional service: Recognize revenue and accrue expected costs Consider following in determination of whether additional service is being provided: whether warranty is required by law, length of warranty period, nature of tasks to be performed

Revenue Recognition Other revenue issues Other Issues • Customer unexercised rights (breakage): Relatively consistent with current US GAAP • Licensing and rights to use: Same guidance as other goods and services Revenue recognized at point in time when control transfers if separate performance obligation

Revenue Recognition Other revenue issues Disclosure / transition/ effective date • Effective no earlier than 2015 for public companies and 2016 for non-public companies

Revenue Recognition • FASB and IASB Convergence Project Five Steps • Identify contract with the customer • Identify separate performance obligations • Determine the price • Allocate the price to the performance obligations • Recognize revenue as performance obligations are satisfied

Revenue Recognition • FASB and IASB Convergence Project Background and Development of the Thought Process The convergence project has been established in order to ease the FASB transition to International Financial Reporting Standards

Revenue Recognition • FASB and IASB Convergence Project International Financial Reporting Standards (IFRS) are based upon accounting principles as opposed to the FASB rules based approach. Accounting principles used in the development of the revenue recognition model include: substance over form, monetary unit assumption, cost principle, full disclosure principle, matching, materiality, conservatism. Also, the revenue recognition principle indicates that revenue is recognized upon sale or service performance

Revenue Recognition