New Revenue Recognition Standard with an emphasis towards Contractors and Manufacturers David LaRosa, CPA, CGMA, CCIFP CBIZ MHM, LLC | Director & Mayer Hoffman McCann P.C. |  Shareholder

David A. LaRosa, CPA, CCIFP Shareholder, Mayer Hoffman McCann P. C David A. LaRosa, CPA, CCIFP Shareholder, Mayer Hoffman McCann P.C. Director, CBIZ MHM, LLC With twenty-four years of experience in public accounting, including twenty in construction accounting, Mr. LaRosa is a licensed CPA in Pennsylvania & New Jersey, who practices public accounting through Mayer Hoffman McCann P.C. (MHM), an independent CPA firm. Mr. LaRosa is a Director in the Accounting group of CBIZ MHM, LLC. Based in Plymouth Meeting, Mr. LaRosa manages accounting and auditing engagements for real estate developers, construction contractors, manufacturing companies, and employee benefit plans. Mr. LaRosa has passed the AICPA International Financial Reporting Standards (IFRS) certification and has some engagements under IFRS standards. In addition Mr. LaRosa has taught many accounting topics in the past ten years to various Continuing Education Societies, has been a national training instructor for Mayer Hoffman McCann P.C., and is a volunteer speaker for the PICPA teaching various topics to grade school, high school and college age students. A graduate of Loyola University in Maryland with a Bachelor of Business Administration in Accounting, Mr. LaRosa is an active member of the Construction Financial Management Association (CFMA); Associated Builders and Contractors (ABC); American Institute of Certified Public Accountants (AICPA) and the Pennsylvania Institute of Certified Public Accountants (PICPA). Mr. LaRosa is the Treasurer of ABC and serves on ABC’s executive committee and board. 610-862-2398 (w) ; 215-519-6457 (c); dlarosa@cbiz.com .

Why the change? Revenue recognition has evolved into a complex and confusing patchwork of different rules that can vary widely from industry to industry. In order to simplify and improve revenue recognition and disclosure, the FASB and IASB initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS 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 (Users of both GAAP and IFRS financials feel revenue disclosures are insufficient in analyzing an entity’s revenue) Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. 3

Issue Date and Standard Numbers On May 28, 2014, the Boards issued a converged standard on revenue recognition from contracts with customers, ASU 2014-09 (Topic 606) and IFRS 15. The FASB and IASB held or participated in over 650 meetings around the world with a variety of stakeholders. FASB and IASB regularly consulted with advisory groups such as the IFRS Advisory Council, the Global Preparers Forum, and the Capital Markets Advisory Committee. 4

Effective Date Topic 606 requires public organizations to apply the new revenue standard to annual reporting periods beginning after December 15, 2017 (Calendar year- end December 31, 2018). Nonpublic organizations would be permitted to apply the new revenue standard to annual reporting periods beginning after December 15, 2018 (calendar-year end December 31, 2019), and interim reporting within annual reporting periods beginning after December 15, 2019. Early application is permitted only as of annual reporting periods beginning after December 15, 2016 (Calendar-year end December 31, 2017). 5

Available Resources from AICPA The AICPA member benefit resources in the Financial Reporting Center at www.aicpa.org/revenuerecognition The AICPA has formed 16 Industry Task Forces to help develop a new Accounting Guide on Revenue Recognition that will provide illustrative examples. AICPA issued an Audit Guide to Revenue Recognition for Topic 606. 6

The new Revenue Recognition Model The core principle of the new model is that an entity would recognize revenue as it transfers a good or service to customers in an amount reflecting the consideration it expects to receive. An entity needs to apply a five step model to achieve that core principle. 7

Core Revenue Recognition Steps 1. Identify contract with the customer 2. Identify separate performance obligations in the contract 3. Determine the transaction price 4. Allocate transaction price to performance obligations 5. Recognize revenue as performance obligations are satisfied 8

Steps summarized 9 Step 1: Identify the Contract with the Customer A contract is defined as “an agreement between two or more parties that creates enforceable rights and obligations.” The new standard affects contracts with a customer that meet the following criteria: Approval (in writing, orally, or in accordance with other customary business practices) and commitment of the parties; Identification of the rights of the parties; Identification of the payment terms; Contract has commercial substance; and Probable that the entity will collect the consideration to which it will be entitled in exchange for the good or service that will be transferred to the customer. A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (parties). In some cases an entity should combine contracts and account for them as one contract. 9

Steps Summarized (Continued) Step 2: Identify Separate Performance Obligations in the Contract A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. At contract inception, an entity should assess the good or service promised in a contract with a customer and should identify as a performance obligation (possible multiple performance obligations) each promise to transfer to the customer either: A good or service (or 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 that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation. 10

Steps Summarized (Continued) Step 3: Determine the Transaction Price The transaction price is the amount of consideration (fixed or variable) the entity expects to receive in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. To determine the transaction price, an entity should consider the effects of: Variable consideration; Constraining estimates of variable consideration; The existence of significant financing component; Noncash considerations; and Consideration payable to the customer. 11

Steps Summarized (Continued) Step 3 Determine the Transaction Price (Continued) If the consideration promised in a contract includes a variable amount, then the entity should estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. An entity would then include the transaction price some or all of an amount of variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. An entity should consider the terms of the contract and its customary business practices to determine the transaction price. 12

Steps Summarized (continued) Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract The transaction price is allocated to separate performance obligations in proportion to the standalone selling price of the promised good or service. If a standalone selling price is not directly observable, then an entity should estimate it. When estimating the standalone selling price, entities can use one of the following three methods: Adjusted market assessment approach (what entity’s competitors charge) Expected cost plus a margin approach Residual approach (only permitted if the selling price is highly variable and uncertain) Standalone selling price is estimated by subtracting the sum of all observable standalone selling prices of other goods or services promised from the total transaction price 13

Steps Summarized (Continued) Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation The amount of revenue recognized when transferring the promised good or service to a customer is equal to the amount allocated to the satisfied performance obligation, which may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control also includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. When performance obligations are satisfied over time, the entity should select an appropriate method for measuring its progress toward complete satisfaction of that performance obligation. Various methods of measuring progress include the input and output methods. 14

Disclosures An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required about: Contracts with customers including revenue and impairments recognized, disaggregation of revenue, and information about contract balances and performance obligations (including the transaction price allocated to the remaining performance obligations); Significant judgments and changes in judgments - determining the timing of satisfaction of performance obligations (over time or at a point in time), and determining the transaction price and amounts allocated to performance obligations; and Assets recognized from the costs to obtain or fulfill a contract. 15

Transition The new guidance allows companies to select between two transition methods: Full Retrospective method – a company would restate all periods presented as if they had been accounted under the new ASU, originally. Comparative periods would be restated. Retrospective application with a cumulative effect adjustment (simplified approach) – apply to contracts for date of initial application (January 1, 2019 for private companies with a calendar year-end) and new contracts going forward. Comparative periods would not need to be restated. Additional disclosures in reporting periods that include the date of initial application of: a. The amount by which each financial statement line item is affected in the current reporting period by the ASU as compared to the guidance that was in effect before the change. b. An explanation of the reasons for significant changes. 16

EXAMPLE McDermott International, Inc. Contractor for the Energy Industry June 2018 10-Q

Accounting service situation for discussion An accounting firm has issued an engagement letter to its client (XYZ Company) to provide the following services: Reviewed financial statements for the year ended December 31, 2016 for XYZ Company. Prepare the corporate tax return for XYZ Company for the year ended December 31, 2016. Prepare the owner’s tax return (husband and spouse) for the year ended December 31, 2016. The fee for these services listed in the engagement letter is $20,000. The reviewed financial statements will be delivered by February 28, 2017, corporate return by March 15, 2017, and the owner’s return by April 15, 2017. 18

Accounting service questions What is the contract(s)? How many performance obligations are in this contract(s)? What is the transaction price(s)? How do we allocate the transaction price(s)? When should revenue be recognized for the performance obligation(s)? 19

Allocate transaction price to performance obligations Review, corporate return, and individual return are three separate performance obligations and an estimate of the price of each “stand-alone project” needs to be determined. Review - $12,000, Corp. return $4,000, Individual return – $1,000. Revenue Allocation Review ($12,000/$17,000) * $20,000 = $14,100 Corporate ($4,000/$17,000) * $20,000 = 4,700 Individual ($1,000/$17,000) * $20,000 = 1,200 Total Fee $20,000 20

Contractors

Combining Contracts 2 or more contracts entered into at or near the same time with the same customer (or related parties) if one of the following conditions is 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 performance of the other contract; or The goods or services promised are a single performance obligation in accordance with ASC 606-10-25-14 through 25-22. Example – second contract can use the general conditions of the first project with minimal additional cost. 22

Contract Modifications (change orders) An entity shall account for a contract modification as a separate contract if both of the following conditions are met: The scope of the contract increases because the modification results in the addition of promised goods or services that are DISTINCT, and The price of the contract increases by an amount of consideration that reflects the entity’s STANDALONE SELLING PRICE of the additional promised goods and services and any appropriate adjustment to the price to reflect the circumstances of the particular contract. 23

We Must Understand “DISTINCT” A promised good or service is considered DISTINCT if both of these conditions 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 (has utility on its own) This assessment requires judgment by the contractor and its auditors to understand the customer’s business and capabilities; and The entity’s promise to transfer the good or service to the customer is Separately Identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract) (FASB 606-10-25-19(b) 24

We Must Understand “DISTINCT” The new standard concept of DISTINCT is similar to current standard concept of DELIVERABLES A contract that has multiple deliverables has an increased likelihood of containing multiple separate performance obligations. (Previous accounting deliverable example) 25

We Must Understand “DISTINCT” Bundle of goods or services A good or service is not distinct in the context of the contract if the entity provides a significant service of integrating the good or service into the bundle of goods or services that the customer has contracted for (Combined Output). The customer has contracted with a general contractor for a building. All of the cost components must be integrated to produce the building. Therefore, the combined output is a single performance obligation. 26

Series (Does not exist in Current GAAP) Each promised good or service is otherwise distinct. Each promised good or service is substantially the same, but do not need to be identical. Each promised good or service has the same pattern of transfer if both of the following criteria are met: a. Each distinct good or service that is promised in the contract would meet the criteria for a performance obligation satisfied over time, and b. The same method is used to measure progress towards satisfaction of the performance obligation. 27

Series of Performance Obligations Electrical contractor enters into a contract with a franchisee to retrofit multiple stores with a standard security system. Each store system is capable of being distinct. Stores are completed at different times and transfer of control to the customer is done over time. Each store has the same pattern of transfer to the customer. All stores can be combined under the “series” doctrine and treated as a single performance obligation. 28

Recap – How to Have a Single Performance Obligation Contract contains only 1 promise – RARE. If promises in the contract are not distinct – entity must bundle promises into a single performance obligation (a contract can have more than 1 bundle). Promises are distinct – entity must assess if series concept applies and report as a single performance obligation. Concurrently delivered distinct goods or services that have the same pattern of transfer if the outcome is the same as accounting for the goods and services as individual performance obligations. 29

Performance Obligation Example Rehab/refurbish 3 rest areas on the PA Turnpike East of Morgantown Structures, underground utilities, ramps/roads, sidewalks, landscaping, signage and traffic control. Mobilization/demobilization of equipment. 30

Contract details Summarized bid estimate by item: Structures = $30,000,000 Underground utilities = 5,000,000 Ramps/roads = 5,000,000 Sidewalks = 200,000 Landscaping = $200,000 Signage = $50,000 Traffic control = $50,000 Mobilization/demobilization: lump sum $500,000 Total contract: $41,000,000 31

Do separate performance obligations exist? What promises in the contract are distinct, if any? Yes No Distinct (both) Utility Customer can benefit from the services? Separately Identifiable No significant integration service provided? The goods and services are not interdependent, or interrelated? The goods and services are not significantly modified, or customized? Series (both) Are the goods and services substantially the same? Do the goods and services have the same pattern of transfer? 32

Conclusion - Keys 3 performance obligations consisting of each location. Each site is independent of the others. Each site has utility on its own. The absence of any specific location would not affect the other locations in the contract. Possible to combine the sites at each location since they are transferred concurrently and the outcome is the same as accounting for them as individual performance obligations. Mobilization would need to be allocated to each of the 3 performance obligations. 33

Fulfillment Costs Certain costs to fulfill contracts are to be capitalized on the balance sheet and amortized over the period reflecting the transfer of control to the customer. Can elect to expense if the contract is less than a year. Examples Mobilization costs to and from a job-site. Surety bonds and insurance costs for a contract. Engineering and design work for the contract. 34

Capitalized Costs to Obtain a Contract ASC 340-40-25-1 states that the costs of obtaining a contract should be recognized as an asset if the costs are incremental and are expected to be recovered. Those capitalized costs should be amortized “on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.” ASC 340-40-35-1. Straight-line amortization is a possible method. Example – Commissions paid to a salesperson 35

Variable Consideration

Variable Consideration Often, part of the contractual consideration related to a good or service is variable in nature or contingent on future events. (not an all inclusive list): Pending change orders Unpriced change orders Performance bonuses — signing bonus, early completion, savings sharing, etc. Project performance terms Unit pricing with variable units Economic price adjustments Latent defects Penalty provisions 37

Variable Consideration (continued) Variable Consideration – Awards/Incentive Payments Current GAAP- Included in the contract amount and recognized in revenue when it is probable the specified performance standards are expected to be met or exceeded and can be reliably measured Topic 606 (A change from current practice) – Included in the contract amount at the inception of the contract when it is probable there will not be a significant reversal of revenue in the future. Need to use a probability of reversal. GAAP uses a 70%-80% likelihood of occurrence for something to be probable. 38

Variable Consideration (continued) Expected value – the expected value is the sum of probability weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics (recommended when there are several possible outcomes). Most likely amount – the most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of an amount of variable consideration if the contract has only two possible outcomes (e.g. bonus received for meeting a date milestone). 39

Recognition of revenue Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer which can occur at a point in time or over time. Control is transferred over time when at least one of the following criteria is met: A customer receives and consumes the benefits of the contractor’s performance as the contractor performs. A contractor’s performance creates or enhances a customer-controlled asset. An asset with an alternative use to the contractor is not created but the contractor has a right to payment for performance completed to date. Progress is measured using one of the following methods: Input method – revenue recognized relative to the inputs to the expected inputs (cost to cost method used in percentage of completion calculation or other inputs) Output method – recognize revenue based on goods or services transferred relative to the total goods or services promised (feet paved in a roadway to total feet, tax returns delivered for a customer). 40

Liquated Damages (expected value method) Contract Terms A highway contractor enters into a $5,000,000 contract to repave a section of highway. The contract requires achievement of substantial completion after 12 weeks after the notice to proceed and assesses a $10,000/day in liquidating damages for each day substantial completion exceeds target. The contractor records the initial contract based on past experience according to the following table: 41

Liquated Damages (expected value method) 42

Uninstalled Materials – Zero Profit Carve Out The standard redefines the nature of uninstalled materials that an entity must take into consideration when measuring progress under the cost to cost method. It also revises the way revenue is measured throughout the term of the contract. 43

Characteristics of Uninstalled Materials The good is not distinct. The customer is expected to obtain control of the good significantly before receiving services related to the good. The cost of the transferred good is significant relative to the total expected costs to completely satisfy the performance obligation. The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good. 44

Operation of Uninstalled Materials When – At inception, the entity expects all the conditions to be met. Materiality measurement – relation of uninstalled materials to total estimated costs of the performance obligation. How to report: Allocate transaction price equal to cost of uninstalled materials; Recognize material costs as cost of performance as incurred and control is transferred to the customer; and Recognize revenue equal to material costs recognized (zero profit method). When services are rendered and materials are integrated into the performance obligation – No change in recognition or reporting. The materials never enter into the recognition of the cost to cost measure for the performance obligation. The performance obligation transaction price (excluding the transaction price allocated to the uninstalled materials) is recognized throughout the performance based on cost to cost method using all other direct and indirect costs. Since no gross profit ever attaches to uninstalled materials, 100% of gross profit is recognized as the other costs related to the performance obligation are incurred and transferred to the customer. 45

Uninstalled Materials Example 46

Manufacturing

Criteria for Bill and Hold under Topic 606 A bill-and-hold arrangement must meet four criteria for control to have transferred and revenue recognized while the goods have not been physically transferred: The reason for the bill-and-hold arrangement must be substantive. (the customer has requested arrangement); The product must be identified separately as belonging to the customer; The product currently must be ready for physical transfer to the customer; and The entity cannot have the ability to use the product or to direct it to another customer. Shipping and handling may be elected to be treated as fulfillment cost, fulfillment costs are accrued when revenue is recognized. 48

Bill-and-Hold Arrangements - Example On March 1, 2020, Walmart enters into a contract to purchase 500,000 artificial Christmas trees from a Christmas tree manufacturer to be delivered on October 1, 2020, at specified distribution centers. Walmart pays 50% of the balance on April 1, 2020, as a down payment with a remaining payment due September 15, 2020. As of September 1, 2020, all 500,000 Christmas trees have been manufactured and stored with the other standard Christmas tree inventory at the manufacturing plant. When should the Christmas tree manufacturer recognize revenue for the 500,000 artificial Christmas trees being delivered to Walmart? 49

Bill-and-Hold Example (continued) Revenue should not be recognized until delivered to Walmart because the second criteria is not met as the Christmas trees were not separately identified as belonging to Walmart and the product could be used by another customer. 50

Sale with a Right of Return In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons and receive a combination of the following: a. A full or partial refund of any consideration paid; b. A credit that can be applied against amounts owed, or that will be owed, to the entity; or c. Another product in exchange. 51

Sale with Right of Return (continued) To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following: Revenue for transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned); A refund liability; and An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on setting the refund liability An entity’s promise to stand ready to accept a returned product during the return period should not be accounted for as a performance obligation in addition to the obligation to provide a refund. 52

Warranties If a customer has the option to purchase a warranty separately (car and appliance warranties), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the warranty as a separate performance obligation and allocate a portion of the transaction price to that performance obligation. If a customer does not have the option to purchase a warranty separately, an entity should account for the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless the promised warranty, part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. 53

Warranties (continued) In assessing whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, and entity should consider factors such as: Whether the warranty is required by law – If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products; The length of the warranty coverage period – The longer the coverage period, the more likely it is that the promised warranty is a performance obligation (car warranties); or The nature of the tasks that the entity promises to perform – If it is necessary for an entity to perform specified tasks to provide the assurance that the product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks do not give rise to a performance obligation. 54

Warranties (example) An entity, a manufacturer, provides its customer with a warranty with the purchase of a product. The warranty provides assurance that the product complies with agreed-upon specifications and will operate as promised for one year from the date of purchase. The contract also provides the customer with the right to receive up to 20 hours of training services on how to operate the product at no additional cost. How many performance obligations do we have? 55

Warranty example (continued) Contract has Two Separate Performance Obligations Product – The product is distinct because the customer can benefit from the product on its own without the training services. Training Services – The training services are distinct because they are separately identifiable from other promises in the contract and are not highly dependent or highly interrelated with the product. 56

Nonrefundable Upfront Fees (and Some Related Costs) In some contracts, an entity charges a customer a nonrefundable upfront fee at or near contract inception. Examples include joining fees in health club memberships and activation fees in telecommunication contracts. To identify performance obligations in such contracts, an entity should assess whether the fee relates to the transfer of a promised good or service. In many cases, even though a nonrefundable upfront fee relates to an activity that the entity is required to undertake at or near contract inception to fulfill the contract, that activity does not result in the transfer of a promised good or service to the customer. Instead, the upfront fee is an advanced payment for future goods or services and, therefore, would be recognized as revenue when those future goods or services are provided. The revenue recognition period would extend beyond the initial contractual period if the entity grants the customer the option to renew the contract and the option provides the customer with a material right. 57

Assessing Whether a Performance Obligation is Satisfied at a Point in Time or Over Time Case A – The customer pays a deposit upon entering into the contract, and the deposit is refundable only if the entity fails to complete construction of the unit in accordance with the contract. The remainder of the contract price is payable on completion of the contract when the customer obtains physical possession of the unit. If the customer defaults on the contract before completion of the unit, the entity only has the right to retain the deposit. Case B – An entity enters into a contract to provide monthly payroll processing services to a customer for one year. 58

Cases - Answers Case A – The entity determines that it does not have an enforceable right to payment for performance completed to date because until construction of the unit is complete, the entity only has a right to the deposit paid by the customer. Because the entity does not have a right to payment for work completed to date, the entity’s performance obligation is not a performance obligation satisfied over time. Instead, the entity accounts for the sale of the unit as a performance obligation satisfied at a point in time. Case B – The performance obligation is satisfied over time because the customer simultaneously receives and consumes the benefits of the entity’s performance in processing each payroll transaction as and when each transaction is processed. The entity recognizes revenue over time by measuring its progress toward complete satisfaction of that performance obligation. 59