K-deep Dhaliwal, Partner for Moss Adams LLP NSAC 2019 – Monterey, CA ASC 606 Revenue from Contracts with Customers May 23, 2019 K-deep Dhaliwal, Partner for Moss Adams LLP

Agenda Overview of ASC 606 Revenue from Contracts with Customers Five-Step Approach Effective Dates & Transition Implementation Strategy

Why did we need a new Revenue Recognition Standard? GAAP had over 200 separate pieces of guidance on how to recognize revenue Industry specific guidance was producing inconsistent results for economically similar transactions Software licensing Construction Technology Guidance was voluminous, fragmented and complex Old GAAP – realized or realizable

Overview of ASC 606 Revenue from Contracts with Customers Five-Step Process

Five-Step Process RM

Five-Step Approach

Step 1: Identify the Contract Contract: an agreement that creates enforceable rights and obligations Criteria Approval and commitment of the parties – written or oral Identification of rights and payment terms – matter of law Commercial substance – amount of future cash flow is expected to change Collectability is probable at inception – customer’s ability to pay Enforceability of the rights and obligations is a matter of law. Approval can being in writing, orally, or in accordance with customary business practices Commercial substance = the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract. Probable = Future event(s) are likely to occur. Consider only the customer’s ability and intent to pay

Step 2: Identify Performance Obligations Performance obligation: a promise in a contract to transfer a good or service This step will require most of the analysis Criteria Distinct good or service Series of substantially similar distinct goods or services that have the same pattern of transfer

Step 2: Identify Performance Obligations A good or service is distinct if both criteria are met: Benefits the customer on its own 2. Separately identifiable from other promises Isn’t used as an input to produce a combined output Contract to build a building would likely be treated as one distinct performance obligation. Although there are many inputs and unique services/goods that are performed (demolition, foundation, framing, finish) each phase of construction is intended to produce one combined output – the office building. Isn’t highly dependent or interrelated with other goods or services in the contract Example of inputs to produce combined output: A construction contract to build an office building would likely be treated as one distinct performance obligation. Although there are many inputs and unique services/goods that are performed (demolition, foundation, framing, finish work, etc.), each phase of construction is intended to produce one combined output – the office building. 606-10-25-21 c. The goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfill its promise by transferring each of the goods or services independently. Inputs to produce a combined output (customization to provide a software license) – not distinct.

Example - Slotting Fees/Pay to play Manufacturers of consumer products commonly pay retailers fees to have their goods displayed prominently on store shelves (‘slotting fees’), or will pay an up-front fee to customer to obtain a new contract (‘pay to play’) Current GAAP (ASC 605): Amounts generally reduce revenue The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Example - Slotting Fees/Pay to play (cont.) New GAAP (ASC 606): Such slotting or pay to play fees do not provide a distinct good or service to the manufacturer (step 2) as the manufacturer cannot sell the slotting fees separately, and would not obtain any rights or receive benefits without selling products to the retailer. The slotting fee should be treated as a reduction of the transaction price. The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Step 3: Determine Transaction Price Transaction price: amount of consideration which an entity expects to be entitled in exchange for transferring goods or services Complex areas: Variable consideration and related constraints Right of return Consideration shall be given to both the terms of the contract and the customary business practices. Variable consideration/constraints – will look at this concept more in depth on the following slides and look at an example. 606-10-32-5 If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. If, in a contract , an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires. [ASU 2014-09, paragraph 5]]

Step 3: Determine Transaction Price Variable consideration - The transaction price might include an element of consideration that is variable or contingent on the outcome of future events, including (but not limited to): Discounts, rebates, coupons, price concessions, refunds, returns, credits, incentives, performance bonuses, and royalties. Two methods for estimation: Most likely amount Expected Value Consideration shall be given to both the terms of the contract and the customary business practices. Variable consideration/constraints – will look at this concept more in depth on the following slides and look at an example. 606-10-32-5 If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. If, in a contract , an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires. [ASU 2014-09, paragraph 5]]

Step 3: Determine Transaction Price Variable consideration is included in the transaction price to the extent it is probable that there will not be a significant reversal in the amount of cumulative revenue recognized Consider likelihood and magnitude in determining constraints Estimated transaction price is reassessed at the end of each reporting period through end of contract Consideration shall be given to both the terms of the contract and the customary business practices. Variable consideration/constraints – will look at this concept more in depth on the following slides and look at an example. 606-10-32-5 If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. If, in a contract , an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires. [ASU 2014-09, paragraph 5]]

Example #1 - Volume Discounts Manufacturers may provide incentives to their customers through volume discounts. These discounts can take different forms, such as tiered pricing (e.g., discounted pricing on future purchases over a certain volume level) or a discount that applies to all purchases under the agreement (e.g., discounted pricing on a retrospective basis once a certain volume level is met). Current GAAP (ASC 605): Sales incentives offered to customers are typically recorded as a reduction of revenue at the later of the date at which the related sale is recorded by the vendor or the date at which the sales incentive is offered. The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Example #1 - Volume Discounts (cont.) New GAAP (ASC 606): Prospective discount (i.e. tiered pricing) - Generally, if a volume rebate or discount is applied prospectively, the rebate or discount would be accounted for as a customer option (not variable consideration). This is because the consideration for the goods or services in the present contract is not contingent upon or affected by any future purchases. Rather, the discounts available from the rebate program affect the price of future purchases. Retrospective discount (i.e. discount applied once volume is met) – Generally, a volume rebate or discount that is applied retrospectively will be accounted for as variable consideration. This is because the final price of each good or service sold depends on the customer’s total purchases subject to the rebate program. That is, the consideration is contingent upon the occurrence or nonoccurrence of future events. Entities will need to evaluate whether the volume rebate or discount provides the customer with an option to purchase goods or services in the future at a discount that represents a material right (and is therefore accounted for as a performance obligation). The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Example #2 - Demonstrations In-store demonstrations could be included in a contract which requires consideration payable to a customer. Current GAAP (ASC 605): Sales incentives offered to customers are typically recorded as a reduction of revenue at the later of the date at which the related sale is recorded by the vendor or the date at which the sales incentive is offered. New GAAP (ASC 606): An entity needs to determine the transaction price, which is the amount of consideration it expects to be entitled to in exchange for transferring promised goods or services to a customer. Consideration payable by an entity to a customer is accounted for as a reduction of the transaction price unless the payment is for a distinct good or service that the customer transfers to the entity. The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Example # 3 - Rights of Return Current GAAP (ASC 605): Revenue is recognized at the time of sale if future returns can be reasonably estimated. Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognized until the return right lapses if an entity is unable to estimate potential returns. New GAAP (ASC 606): Entities will recognize the amount of consideration received or receivable that is expected to be returned as a refund liability, representing their obligation to return the customer’s consideration. Entities will also recognize a return asset (and adjust cost of sales) for the right to recover the goods returned by the customer. They will initially measure this asset at the former carrying amount of the inventory, less any expected costs to recover the goods, including potential decreases in value of the goods expected to be returned. At each reporting date, they will remeasure the refund liability and update the measurement of the asset recorded for any revisions to the expected level of returns, as well as any additional decreases in the value of the products expected to be returned. Presentation - The standard requires the carrying value of the return asset to be presented separately from inventory and subject to impairment testing on its own, separately from inventory on hand. The standard also requires the refund liability to be presented separately from the corresponding asset (on a gross basis rather than a net basis). The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Example # 3 - Rights of Return (cont.) Assume Apparel Co. offers its customers the right to return any products purchased up to 30 days after sale, for any reason. Last Tuesday, Apparel Co. sold 100 red sweaters to different customers. Based on historical experience, Apparel Co. expects 15 of those sweaters to be returned for a full refund. Each sweater sells for $80 and costs Apparel $35 to produce. Apparel Co. would record the following journal entries for the sale of the sweaters and the expected refund liability and corresponding asset. Cash The FASB staff suggested that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer (or the entity) decides, just as the parties are about to sign the contract, that it will not enter into the contract. If the costs would have been incurred even if the contract is not executed, the costs are not incremental to obtaining that contract. The following are not incremental costs; Costs that are incurred regardless of whether the contract is obtained – a. costs to negotiate or draft the contract B. costs to fulfill at contract – set-up activities No legal costs – would have been incurred whether or not the contract was executed

Step 4: Allocate the Transaction Price Allocate the transaction price to each performance obligation based on a relative standalone selling price basis One performance obligation – simple Multiple performance obligations – more complex One performance obligation – most contracts will likely be treated this way, with highly interrelated activities producing a combined output. Multiple performance obligations – For example, one contract is signed with a customer to construct an office building, and also construct a small parking structure near the office building. The office building and parking structure will be two separate structures (they do not connect and are not integrated in any other way). The office building and parking structure may be considered two distinct performance obligations, as the customer can benefit from each individually and the customer could hypothetically select a different contractor to build either structure without significantly affecting the other structure. Under this scenario, the transaction price specified in the contract would have to be allocated to each performance obligation (the building and the parking structure) based on their relative “standalone selling prices”.

Step 4: Allocate the Transaction Price Standalone selling price is the price at which the entity would sell a good or service to a customer Doesn’t require the good or service to actually be sold Best evidence of standalone selling price is the observable price of a good or service sold separately For VSOE, you had to sell it. Now changes to WOULD sell. No longer requiring VSOE study – stand alone selling price will always exist.

Step 4: Allocate the Transaction Price If no observable sales, estimate standalone selling price based on the following methods: Top-down approach Adjusted market assessment Bottom-up approach Expected cost plus a margin

Step 5: Recognize the Revenue An entity recognizes revenue when (or as) the entity satisfies a performance obligation by transferring the goods or services to a customer An asset (good or service) is considered transferred when (or as) the customer obtains control of the asset Control of an asset refers to the ability to direct the use of , and obtain substantially all of the remaining benefit from the asset.

Step 5: Recognize the Revenue Recognize revenue when or as a performance obligation is satisfied Two methods: At a point in time Over time

Step 5: Recognize the Revenue Revenue is recognized over time if: The customer simultaneously receives and consumes the benefits as the entity performs; or The entity’s performance creates or enhances an asset that the customer controls; or The entity’s performance doesn’t create an asset with an alternative use to the entity and enforceable right to payment exists. If any of these criteria are met then revenue is recognized over time. For contractors the 2nd criteria might be met in some instances, but generally the third criteria will be present and will cause revenue to be recognized over time.

Five-Step Process – Summary

Effective Dates & Transition

Effective Dates Public Entities Effective date - periods beginning after 12/15/17 Early adoption beginning after 12/15/16 Nonpublic Entities Effective date - periods beginning after 12/15/18 Early adoption permitted up to the public entity early adoption date For a public entity, the amendments are effective for annual reporting periods beginning AFTER December 15, 2016. For calendar YE companies, that would be December 31, 2017. Remember a public entity – isn’t just a company that securities listed in the public market. Public entities also include not-for-profit entities that have issued, or is a conduit bond obligor. For public entities, this also includes interim reporting during the period of adoption. Calendar YE nonpublic entities, would adopt for the 12/31/2019 ye. For nonpublic, interim periods do not have to reflect the adoption until periods beginning after 12/15/2018. So for calendar YE companies. This would be interim periods in 2019.

Transition – Full Retrospective Retrospective to each prior period reported with practical expedients: Completed contracts that begin and end in the same annual reporting period do not need to be restated Completed contracts with variable consideration, can use the transaction price at the completed contract date For reporting periods prior to initial adoption don’t need to disclose the portion of the transaction price allocated to the remaining performance obligation Disclose prior-period information that has been adjusted

Transition – Modified Retrospective Retrospectively with the cumulative effect recognized at the date of initial application. Any necessary adjustments would be recorded to opening retained earnings on the date of adoption—prior periods wouldn’t be restated. This would involve comparing how those contracts would have been recorded under Topic 606 with how they were actually recorded under legacy GAAP. Must provide additional disclosure in the reporting period of initial application Disclose effects of adoption on each FS line item Explanation for the reasons for any significant changes in financial reporting based on the new standard Modified Retrospective – Cumulative effect adjustment represents application of new guidance only to contracts not yet completed as of the date of adoption. Recognize the cumulative effect of initial application as an adjustment to the opening balance of retained earnings or other appropriate component of equity or net assets. With this method, the guidance is only applied to contracts that are not completed at the date of the initial application. For example, open contracts as of January 1, 2018 for a nonpublic entity with a December 31 year end. Modified retrospective – Disclosure requirements will require financial information about the period of adoption as if it were accounted for under existing guidance. This is because the multi-period income statement won’t be truly “comparative” since the current period and prior period(s) will be accounted for under two different methods of accounting.

Implementation Strategy

Implementation Strategy PHASE I – INITIAL ASSESSMENT Step 1 – Familiarize yourself with the standard Step 2 – Perform high level assessment - discuss gray areas with Moss Adams Step 3 – Document high level impact/summary PHASE II – PLANNING Step 4 – Detailed plan – timeline, resources, budget, transition approach Step 5 – Controls & systems impact – Reports, tools, templates PHASE III – IMPLEMENTATION Step 6 – Document accounting processes/controls Step 7 – Perform contract analysis/data aggregation Step 8 – Document technical accounting memos & financial statement disclosures