Technical Line: The revised revenue recognition proposal ... · Accounting Standards Codification. • Applying the proposal would require companies to evaluate performance obligations

What you need to know • The FASB and the IASB issued a second exposure draft of their converged

revenue model that is closer to current US GAAP than their 2010 proposal.

• The proposed model would apply to all entities in all industries and would

replace all of the general and industry-specific revenue guidance in the

Accounting Standards Codification.

• Applying the proposal would require companies to evaluate performance

obligations at a lower, more detailed level than under current US GAAP.

• The proposal may require entities in the A&D industry to use an input method,

such as a “cost-to-cost” approach, to depict continuous transfer of goods and

services that have been identified as a single performance obligation. Many

entities today use a “units of delivery method.”

• The proposal will significantly increase the volume of financial statement

disclosures.

Overview The revised revenue recognition proposal issued by the Financial Accounting

Standards Board (FASB) and the International Accounting Standards Board (IASB)

(collectively, the Boards) could result in significant changes in practice for

aerospace and defense (A&D) companies.

In this publication, we focus on the following areas that we expect to be of interest

to A&D companies as they consider the potential effects of the proposal:

• Accounting for contract modifications

No. 2012-06

1 February 2012

Technical Line FASB — proposed guidance

In this issue:

Overview ........................................... 1

Background ....................................... 2

Step 1: Identify the contract .............. 2

Step 2: Identify the separate performance obligations ................ 6

Step 3: Determine the transaction price ........................... 9

Step 4: Allocate the transaction price ......................... 10

Step 5: Satisfaction of performance obligations .............. 12

Other measurement and recognition topics ........................ 15

Onerous performance obligations ... 15

Variable or contingent fees ........... 16

Contract costs .............................. 16

Disclosures ...................................... 18

Federal government contract accounting and compliance .......... 19

The revised revenue recognition proposal — aerospace and defense

Ernst & Young AccountingLink

www.ey.com/us/accountinglink

2 1 February 2012 Technical Line The revised revenue recognition proposal — aerospace and defense

• Assessing whether performance obligations are distinct

• Allocating the transaction price to separate performance obligations

• Determining whether control transfers over time

• Accounting for contract costs

This publication supplements our Technical Line, Double-exposure: The revised

revenue recognition proposal (SCORE No. BB2231), which describes the Boards’

November 2011 Exposure Draft (ED) in detail, and should be read in connection

with it.

We encourage A&D companies to read this supplement carefully and consider the

potential effects that the proposed model could have on their revenue recognition

practices. The discussions in this publication do not represent final or formal views

because the proposal could change as the Boards deliberate further.

Background The proposal specifies the accounting for all revenue arising from contracts with

customers and affects all entities that enter into contracts to provide goods or

services to their customers (unless those contracts are in the scope of other US

GAAP requirements).

The principles in the proposed standard would be applied using the following five steps:

1. Identify the contract(s) with a customer

2. Identify the separate performance obligations in the contract(s)

3. Determine the transaction price

4. Allocate the transaction price to the separate performance obligations

5. Recognize revenue when the entity satisfies each performance obligation

The proposed guidance would also provide a model for the measurement and timing

of recognition of gains and losses on the sale of certain nonfinancial assets, such as

property and equipment.

Step 1: Identify the contract with a customer To apply the proposal, an entity would first identify the contract, or contracts, to

provide goods or services to its customers. Contracts could be written, oral or

implied by an entity’s customary business practices.

Generally speaking, the step of identifying the contract with the customer would

not differ significantly from current practice. For example, the proposed guidance

on combining two or more contracts entered into with the same customer at or

near the same point in time into a single contract for accounting purposes is

consistent with the existing literature. As a result, we anticipate that entities would

reach conclusions about combining contracts that are similar to today’s

conclusions. However, there may be some changes from current practice, primarily

involving accounting for contract modifications.




Contract modifications

Contract modifications occur frequently in the A&D industry, including modifications

where the parties have agreed to change the scope of the contract but have not yet

agreed on a price (frequently referred to as unpriced change orders).

Under the proposal, contract modifications are defined as changes to the scope of

work, the price or both that have been approved by both parties to the contract.

While the ED indicates that modifications would have to be approved by the parties to

the arrangement, it also makes clear that unpriced change orders (that is, a change in

scope that has been approved but the change in price has not yet been determined)

are meant to be considered contract modifications and would be accounted for when

the entity has an expectation that the pricing change will be approved.

The ED outlines a number of ways to account for contract modifications, depending

on the characteristics of the modification and the underlying arrangements. The

alternatives are as follows:

• If the modification changes only the pricing of the promised goods or services,

the change would be treated as a change in the estimated transaction price.

Under the proposal, a change in estimated transaction price after contract

inception would be allocated to the separate performance obligations in the

same manner that the initial estimated transaction price was allocated.

Illustration 1 — Change in price

A contractor entered into an arrangement to provide customized

communication modules to the US Government. The contract includes a

design phase, production and delivery of 60 modules, and maintenance of

the delivered modules. The design phase, the production and delivery phase

and maintenance are three separate performance obligations (see page 6 for

further discussion of identifying separate performance obligations).

At contract inception, the total transaction price of $10,000,000 was

allocated to each performance obligation, based on their relative standalone

selling prices.

Standalone selling price

% of total

Contract price Allocation

Design services $3,000,000 26% $2,000,000 $2,600,000

Production and delivery 7,500,000 65% 7,500,000 6,500,000

Maintenance 1,000,000 9% 500,000 900,000

$11,500,000 100% $10,000,000 $10,000,000

Due to an increase in anticipated costs, the contractor and the customer

agree during the production/delivery phase to increase the price of the

overall contract by $1,000,000.

Because this modification represents only a change in price, the revised

transaction price would be allocated to the separate performance obligations

based on the standalone selling prices used at contract inception.

The proposal may

result in a change

in accounting for

contract modifications.




Illustration 1 — Change in price (continued)

Standalone selling price

% of total

Contract price Allocation

Design services $3,000,000 26% $2,000,000 $2,860,000

Production and delivery 7,500,000 65% 8,500,000 7,150,000

Maintenance 1,000,000 9% 500,000 990,000

$11,500,000 100% $11,000,000 $11,000,000

Because the contractor had already completed the design phase and

recognized the revenue allocated to that performance obligation

($2,600,000), the contractor would need to recognize the additional

revenue allocated to this performance obligation to reflect the change in

transaction price that was allocated to the design phase ($260,000).

If the contractor recognized revenue related to the production/delivery

phase, additional revenue would be recognized on a “cumulative catch-up”

basis to reflect the additional progress toward completion in the period in

which the modification was finalized.

• When a modification changes the scope of an arrangement or the scope and

pricing of an arrangement, the modification might be treated as a separate

contract. That is, if the modification results in additional distinct goods and

services and the promised consideration associated with those goods and

services reflects the entity’s standalone selling price, the additional distinct goods

or services and related consideration would be treated as a separate contract.

Illustration 2 — Change in scope and price

A contractor entered into an arrangement to provide communication

modules to the US Government. The contract includes production and

delivery of 60 modules and maintenance on the delivered modules. At

contract inception, the total transaction price of $10,000,000 was allocated

to each performance obligation, based on their relative standalone selling

prices. Midway through the production phase, the contractor and customer

renegotiate the contract. The contractor agrees to provide 30 more

communication modules for additional consideration of $3,750,000.

Because the modification results in a change in both the scope and price of

the arrangement, the contractor must determine whether the additional

goods are distinct and the additional consideration is consistent with the

standalone selling price. In this scenario, the additional 30 modules are

distinct because they are sold regularly by the contractor on a standalone

basis. Furthermore, the additional units are priced at $125,000 per unit,

which is consistent with their standalone selling price.

As a result, the 30 additional communication modules and consideration of

$3,750,000 would be treated as a separate contract. The contractor would

not change the accounting for the original contract.




• Contract modifications in which the additional goods or services are not distinct

and the promised consideration associated with the additional goods or

services does not reflect the standalone selling price would not be treated as

separate contracts. Contract modifications that modify or remove previously

agreed to goods and services would also not be treated as separate contracts.

An entity would account for the effects of these modifications differently,

depending on the situation:

• If the goods and services not yet provided are distinct from the goods and

services provided before the modification, the entity would allocate any

consideration not yet recognized as revenue to the remaining separate

performance obligations. In effect, this approach would treat the contract

modification as a termination of the old contract and the creation of a new

contract. While this is not explicitly stated in the ED, we believe that an

entity also would have to reflect in the allocation of the revised transaction

price any changes in the standalone selling prices of the remaining goods

and services.

• If all of the promised goods and services are part of a single performance

obligation (i.e., the goods and services not yet provided are not distinct

from the goods and services provided to date) and that performance

obligation is partially satisfied as of the date of the modification, the entity

would account for the modification as if it were part of the original contract

and would recognize the effect of the modification on a cumulative

catch-up basis. This approach would effectively treat the modification as

part of the original contract.

• If the goods and services not yet provided are a combination of the two

scenarios above, the entity would allocate all remaining consideration to the

unsatisfied (including partially unsatisfied) performance obligations. The

entity would exclude any completely satisfied performance obligations from

this allocation. Again, to perform this reallocation, we believe entities would

have to update their estimates of standalone selling price for each separate

performance obligation. For performance obligations satisfied over time

that are partially satisfied as of the date of the modification/reallocation, the

entity would update the measure of progress based on any changes in the

performance obligations and allocated transaction price on a cumulative

catch-up basis.

Illustration 3 — Change relates to a single performance obligation

A government contractor enters into an arrangement with the US

Government to design and implement a customized software solution for

facility management at military bases across the country. There is a design

phase and an implementation phase at 120 sites for total consideration of

$4.8 million. The design phase is scheduled to last 18 months, and the

implementation phase will occur over the following 18 months. Total costs

for design and implementation are expected to be $3.4 million. Assume that

the contractor determines that it has a single performance obligation (see

below for further discussion) and that the performance obligation is satisfied

over time, based on the criteria for continuous revenue recognition

(discussed further on page 11). In addition, assume the contractor

determines that a cost-to-cost approach best depicts its measure of progress

toward satisfaction of the performance obligation.




Illustration 3 — Change relates to a single performance obligation

(continued)

Nine months into the contract, the contractor and the US Government agree

to add 30 sites to the contract and increase the total compensation. Due to

matters identified early in the design phase, the contractor was forced to use

a different software platform in the design phase, which significantly

increased costs. To compensate the contractor for these additional costs and

for the additional 30 sites, the government agreed to increase the total

consideration to $6.8 million. The contractor concludes that the additional

$2 million of compensation exceeds the standalone selling price for

implementation at the additional 30 sites.

In this scenario, the contractor would likely conclude that all of the promised

goods and services (including the additional 30 sites) are part of a single

performance obligation, consistent with its original conclusion. Therefore,

the proposed guidance would require the contractor to update the

transaction price and the measure of progress toward satisfaction of the

performance obligation as of the date of the modification, rather than treat

the modification as a separate contract.

Up to the date of the modification, the contractor had incurred costs of $1

million. Therefore, the contractor determined it was 29% complete in

satisfying its performance obligation ($1 million / $3.4 million) and had

recorded $1.4 million in revenue (29% X $4.8 million). Based on the revised

number of sites under the modified agreement, the contractor determines it

is 22% complete ($1 million / $4.4 million). Accordingly, the contractor

determines cumulative revenue to date should be $1.5 million, compared

with the $1.4 million recorded to date, and recognizes an adjustment to

increase revenue by $100 thousand.

How we see it We believe that using a cumulative catch-up adjustment approach for contract

modifications that relate to a single performance obligation that is partially

satisfied as of the date of the modification (as described in Illustration 3) would

be most common in the A&D industry. We do not believe that the accounting

treatment under the proposal would differ significantly from current practice.

However, if an entity had identified more than one performance obligation in the

contract and determined that, at the time of the modification, some or all of the

completed performance obligations were distinct from those still to be provided,

the proposal would require accounting that would likely be different from

current practice.

Step 2: Identify the separate performance obligations The proposal defines a performance obligation as “an enforceable promise

(whether explicit or implicit) in a contract with a customer to transfer a good or

service to the customer.” The goods or services promised in a customer contract

(either explicitly stated in the contract or implied by customary business

practices) are the potential performance obligations.

Performance obligations

would replace the

“profit center” as the

unit of account for cost

accumulation and revenue

recognition.




How we see it This definition of a performance obligation would replace the “profit center”

as defined in ASC 605-35 as the unit of account for cost accumulation and

revenue recognition. The ED would require an entity to identify all promised

goods and services within a contract and determine whether to account for each

of them as a separate performance obligation. ASC 605-35 presumes that the

entire contract is the profit center unless the criteria for combining or

segmenting are met.

Distinct goods and services

After identifying the promised goods and services, an entity would determine which

of them would be accounted for as separate performance obligations. That is, the

entity would identify which goods and services represent individual units of

account. The proposal outlines a two-step process for making this determination.

An entity would consider whether the individual goods or services promised in the

contract are distinct. Goods and services would be distinct when either:

• The entity regularly sells the good or service separately.

• 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 (from

the entity or from another entity).

The proposal would then require the entity to consider how those goods and

services have been bundled. The proposal specifies that goods and services within a

bundle would not be distinct if both of the following criteria are met:

• The goods or services are highly interrelated, and transferring the goods or

services requires integration into a combined item.

• The bundle of goods or services is significantly modified or customized to fulfill

the contract.

Finally, the proposal provides a practical expedient that would allow an entity to

account for multiple distinct goods or services as one performance obligation when

the underlying goods and services have the same pattern of transfer. In the basis

for conclusions section, the proposal indicates that the same pattern of transfer

would not strictly relate to two or more performance obligations transferred

simultaneously. We believe that performance obligations transferred consecutively

with a similar pattern (for example, two performance obligations where progress is

measured using labor hours) could also be combined as one performance obligation

under this provision.

We generally believe this guidance addresses many of the concerns raised by A&D

respondents about the 2010 ED in that, for many A&D contracts, it will result in the

identification of a single performance obligation that will be satisfied over time.

However, the required assessment of distinct performance obligations may be

complex and will require the use of judgment, taking into consideration all of the

facts and circumstances. As is the case in assessing the applicability of ASC 605-35

under current US GAAP, the level of customization of products and services

required by the contract would be a key consideration.




The following example illustrates how an entity might consider each of the criteria

described above.

Illustration 4 — Multiple goods and services

An aerospace manufacturer enters into a contract with the US Navy to design,

construct and maintain 10 combat aircraft.

Scenario A

Because the manufacturer is designing a new aircraft platform on which to base

the 10 aircraft, the manufacturer anticipates significant design modifications as

the construction phase begins. The design and construction of the aircraft

involves multiple goods and services from various technical resources and

complex procurement and installation of all of the materials. Several of the goods

and services could be considered separate performance obligations because the

manufacturer regularly sells the services such as engineering and construction

services based on third-party designs on a standalone basis.

However, because of the relationship between design and construction (i.e., the

two phases are highly interrelated), the manufacturer determines that these

goods and services represent a single distinct performance obligation. This is

supported by the significant customization and modification of the design and

construction services required to fulfill the obligation under the contract.

However, the manufacturer concludes that the maintenance phase of the

arrangement is not highly interrelated with the design and construction services,

and that phase is a separate performance obligation.

Scenario B

The 10 aircraft are based largely on an existing platform with only limited design

changes expected. The manufacturer does not believe there will be significant

redesign in the construction phase given its history with the platform. Although

the construction depends on the design, the design does not depend on the

construction. Further, the design services and construction services are fulfilled

with separate resources.

The manufacturer concludes that the design and construction phases are not

highly interrelated. Because the proposal would require goods and services to be

both highly interrelated and significantly customized or modified to be treated as

a single performance obligation, the design and construction phases would each

be accounted for as separate performance obligations.

Further, the manufacturer would likely determine that each of the 10 aircraft

represents a distinct performance obligation.

The manufacturer concludes that the subsequent maintenance of the aircraft

would not be bundled with the design or construction phases of the contract. The

subsequent maintenance activities are not highly interrelated with the design and

construction phases. Therefore, all three phases would be treated as separate

performance obligations.




How we see it Applying this proposed guidance would require entities to assess potential

performance obligations at a lower level than is currently required and may

result in the identification of multiple performance obligations for each contract.

In the A&D industry, it is common for arrangements to require a contractor to

manufacture many components and perform a variety of tasks to deliver an

overall system solution. In such cases, the goods and services may represent a

bundled solution or several distinct performance obligations. Understanding the

relationship of the deliverables within the arrangement to one another as well as

the level of customization involved in the ultimate deliverable would be critical.

Significant judgment would be required.

Customer options for additional goods or services

It is common for contracts to allow customers to exercise options to obtain

additional goods or services. Under the proposal, if an option provides a material

right to the customer, it would be considered a separate performance obligation. A

material right would include a significant incremental discount on the goods or

services not otherwise available to the customer. If an entity determines that an

option does not provide a material right to the customer, the option would be

considered a marketing offer and not a separate performance obligation. An entity

that determines that an option is a separate performance obligation would have to

determine the separate standalone selling price (discussed further below) of the

option, taking into consideration the discount the customer would receive and the

likelihood the customer will exercise the option. A portion of the transaction price

would then be allocated to the option.

Current US GAAP also contemplates combining options with the existing contract if

the discount is significant and is incremental both to the range of discounts

reflected in the pricing of other elements in that contract and to the range of

discounts typical in comparable transactions. Therefore, while the concept of

accounting for an option that provides the customer with a material right would not

be a change from current guidance, the proposal may change how much of the

transaction price should be allocated to that option.

The proposal would require entities to identify and allocate arrangement

consideration to an option on a relative standalone selling price basis, which is

consistent with current US GAAP. However, the proposal also provides an

alternative treatment for options when there is no observable standalone selling

price. Under the alternative, the entity would estimate the transaction price by

including any consideration related to the optional goods or services, then

allocating that transaction price to all of the goods and services (including those

under option).

Step 3: Determine the transaction price The proposal defines the transaction price as “the amount of consideration to which

an entity expects to be entitled in exchange for transferring promised goods or

services to a customer, excluding amounts collected on behalf of third parties (for

example, sales taxes).” In many cases, the transaction price is readily determined

A contractor’s accounting

for options to purchase

additional goods or

services may change

under the proposal.




because the entity receives payment at the same time it transfers the promised

goods or services and the price is fixed. Determining the transaction price may be

more challenging when it is variable in amount, when payment is received at a time

different from when the entity provides goods or services or when payment is in a

form other than cash. Consideration paid or payable by the vendor to the customer

also may affect the determination of transaction price.

It is important to note that the current proposal contains certain significant changes

from the 2010 ED. First, the proposal would no longer require collectibility to be

considered when determining the transaction price. Additionally, while the time

value of money would have to be considered in an arrangement, the Boards tried to

reduce the number of contracts to which that provision would apply. In the current

proposal, the time value of money would be considered only when there is a

significant financing component in an arrangement. In addition, an entity would not

be required to assess whether the arrangement contains a significant financing

component unless the period between the customer’s payment and the entity’s

satisfaction of the performance obligation is greater than one year. The Boards also

clarified that they do not believe contract retainage provisions (that is, amounts

withheld by the customer from invoices to ensure performance through

completion), which are common in the A&D industry, are financing components.

Step 4: Allocate the transaction price Once the performance obligations are identified and the transaction price has been

determined, the proposal would require an entity to allocate the transaction price

to the performance obligations, generally in proportion to their standalone selling

prices (i.e., on a relative standalone selling price basis). As a result, any discount

within the contract would generally be allocated proportionally to all of the separate

performance obligations in the contract.

However, there would be some exceptions. For example, the proposal contemplates

the allocation of any discount in an arrangement to only one or some of the

performance obligations if certain criteria are met. This provision is meant to replace

the segmenting provision that was removed from the 2010 ED. Specifically, the

current ED would allow an entity to allocate a discount inherent in a bundle of goods

and services to an individual performance obligation (or smaller bundle of goods and

services) when the pricing of that good or service is largely independent of others in

the contract. That is, an entity would be able to effectively “carve off” an individual

performance obligation and allocate a discount to that performance obligation if the

entity determines the discount is specific to that good or service. The ED states that

the price of goods and services would be largely independent of other goods and

services in the contract when both of the following criteria are met:

• The entity regularly sells each good or service (or each bundle of goods or

services) in the contract on a standalone basis.

• The observable selling prices from those standalone sales provide evidence of the

performance obligation(s) to which the entire discount in the contract belongs.

However, it is not clear how this guidance would be applied if the bundle of goods

and services has a discount larger than the amount attributed to certain goods

and services.




Illustration 5 — Allocating discounts

A government contractor enters into an arrangement with a customer to

implement an off-the shelf software package, which will include the delivery of

hardware, peripherals and servers for total consideration of $1,450,000. The

hardware, peripherals and servers will be delivered at or near inception of the

arrangement. The software and implementation services will be delivered

approximately three months later.

The contractor regularly sells the hardware, peripherals and services separately,

and the off-the-shelf software and implementation services are often sold as a

bundle.

The package price and standalone selling prices of each good or service are as

follows:

Item Standalone selling price

Price when bundled

Bundling discount

Implementation services $ 150,000 $ 975,000 $ 75,000

Off-the-shelf software 900,000

Computer hardware 125,000 125,000 —

Peripherals 75,000 75,000 —

Servers 275,000 275,000 —

$ 1,525,000 $ 1,450,000 $ 75,000

Due to the timing of delivery, the contractor chooses to account for three

performance obligations — all items delivered up front (hardware, peripherals,

and servers) — as a single performance obligation, and the software and

implementation services as two other performance obligations.

Because the contractor regularly bundles the software and services and sells

them on a combined basis at a $75,000 discount, the contractor has observable

evidence that the $75,000 discount inherent in the package is attributable to the

bundle. Therefore, the contractor would allocate 100% of the discount to the

bundle, as shown:

Allocated amounts

Software and implementation services bundle $ 975,000

Hardware, peripherals and servers 475,000

Total $ 1,450,000

This example assumes the discount for the larger bundle of goods and services is

exactly equal to the discount for a bundle ($75,000). It is unclear how an entity

would treat a discount of more than $75,000 for the larger bundle. For example,

if the discount on the larger bundle totaled $125,000, it is unclear whether

$75,000 would be allocated to the bundle and the remainder would be allocated

to the other three items or whether the entire $125,000 discount would be

allocated to all of the performance obligations based on the relative standalone

selling prices (i.e., the entity would not be able to use the exception to allocate a

discount to only certain performance obligations as discussed above).




How we see it The proposed guidance on allocating the transaction price is similar to the

current guidance in ASC 605-25. While ASC 605-35 provides guidance on

contract separation, that guidance does not address allocation of arrangement

consideration. In practice, separately negotiated prices for contract components

are generally used as the value of separated contract elements. The proposal,

which would require allocation based on a relative standalone selling price

method, could result in a significant change in practice.

The proposed requirement to allocate discounts to a single performance

obligation (as illustrated above) would be a significant change from current

practice. However, we do not believe many companies in the A&D industry

would meet the criteria due to the prevalence of customized solutions in

contracts. Companies that provide goods or services under a General Services

Administration (GSA) schedule, however, may be affected by this requirement.

Step 5: Satisfaction of performance obligations Under the proposal, an entity would recognize revenue only when it satisfies a

performance obligation by transferring a promised good or service to a customer. A

good or service is generally considered to be transferred when the customer

obtains control. The ED states that “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 receiving the benefit from a good or service.

The proposal indicates that certain performance obligations are satisfied as of a

point in time and revenue would be recognized at that point in time. Other

performance obligations are satisfied over time, and the associated revenue would

be recognized over the period the performance obligation is satisfied. Constituents

had raised concerns that the 2010 ED did not adequately address the concept of

control transferring over time and could have forced many arrangements to be

treated as if control transferred at a point in time. In the 2011 ED, significant

changes have been made to address these concerns.

Performance obligations satisfied over time

Frequently, entities transfer promised goods and services to the customer over

time. While the determination of whether goods or services are transferred over

time is straightforward in some arrangements (e.g., many service contracts), the

Boards acknowledged that it was more difficult in many other arrangements. To

help entities determine when control transfers over time (rather than at a point in

time), the Boards provided the following guidance:

• The entity’s performance creates or enhances an asset (such as work in

process) that the customer controls as the asset is created or enhanced. For

example, contracts with the US Government frequently provide that the US

Government takes title to items produced as the work is performed.

Many performance

obligations in A&D

arrangements would likely

meet the proposed

criteria for recognizing

revenue over time.




• The entity’s performance does not create an asset with an alternative use to

the entity (for example, if the contract includes provisions that prevent the

transfer of the goods and services to another party) and at least one of the

following criteria is met:

• The customer simultaneously receives and consumes the benefits of the

entity’s performance as the entity performs (for example, training provided

to government employees).

• Another entity would not need to substantially re-perform the work

the entity has completed to date if that other entity were to fulfill the

remaining obligation to the customer (for example, transporting goods

for the government).

• The entity has a right to payment for performance completed to date, and

it expects to fulfill the contract as promised. The right to payment for

performance completed to date does not need to be for a fixed amount.

However, the entity must be entitled to an amount that is intended to at

least compensate the entity for performance completed to date even if the

customer can terminate the contract for reasons other than the entity’s

failure to perform as promised. For example, it is common for

arrangements in the A&D industry to include provisions that permit the

government to terminate the contract and take possession of any work in

process with payment to the entity for performance completed to date.

We believe that many of the arrangements in the A&D industry, and in particular

those with the US Government (under the Federal Acquisition Regulation (FAR))

would be considered contracts where performance obligations are satisfied over time.

How we see it All performance obligations would need to be carefully evaluated to determine

whether they are satisfied over time. We believe many of the performance

obligations within arrangements currently accounted for under ASC 605-35

would meet the proposed criteria to recognize revenue over time rather than at

a point in time.

Measurement of progress

Revenue for a performance obligation satisfied over time would be recognized “by

measuring the progress toward complete satisfaction of that performance

obligation.” The objective is to reflect the entity’s performance under the contract,

similar to existing US GAAP. The proposal specifically identifies both output and

input measures as acceptable measures of progress. This is similar to existing

US GAAP under ASC 605-35, which says output measures are “preferable” but

inputs are acceptable. But this would be a change from existing practice on “service

contracts” under Staff Accounting Bulletin (SAB) Topic 13, Revenue Recognition,

which generally leads companies to use output measures. Also, similar to existing

US GAAP, the proposal would require an entity to have the ability to make

reasonable estimates and to apply completeness measurements in the same

manner across similar contracts to recognize revenue prior to completion.




The proposal provides examples of output measures, which are consistent with

existing guidance in ASC 605-35.1 Further, the proposal specifically indicates that

entities entitled to invoice a customer based on performance (e.g., service

contracts under time-and-materials arrangements) should recognize revenue as

such amounts are billable because the amounts billed reflect an output method.

The proposal also addresses input measures. One key element is that the use of

input measures would not include any measurement that does not depict the

transfer of goods or services to the customer. This concept would apply in the A&D

industry to the up-front purchase of materials on a long-term construction contract.

While such costs are directly related to the contract, they would not be included in

the measurement toward completion until the materials have been integrated into

the final product.

Unlike the guidance in ASC 605-35, the proposal indicates no preference for

output measures over input measures, but does clarify that the selected method

would be consistently applied to similar arrangements containing similar


Illustration 6 — Measuring progress

This is a continuation of Illustration 4 above. Assume that the contract allows the

customer to take title to the work in progress as it is being performed and also

provides that the manufacturer is entitled to payment for efforts to date if the

contract is terminated.

Scenario A

As discussed above, the manufacturer determined that the design and

construction phases represent a single performance obligation. Because the

manufacturer expects that there will be significant design efforts, there will likely

be an extended period of time before it delivers any of the 10 promised aircraft.

Given the contractual clause of title passing to the customer, the manufacturer

determines that transfer of this combined performance obligation happens

continuously. Therefore, the manufacturer has to select the appropriate measure

of progress. However, the manufacturer would likely not choose a “units of

delivery” method as a measure of progress because that method would not

capture accurately the level of performance and would exclude its efforts during

the design phase. In such situations, the manufacturer would likely determine that

an input method, such as a “cost-to-cost” approach, is more appropriate.

Scenario B

In this scenario, the manufacturer determined the design and construction

phases would each be accounted for as separate performance obligations.

Further, the manufacturer would likely determine that each of the 10 aircraft

represents a distinct performance obligation.

Therefore, the manufacturer would have to determine the appropriate method for

measuring progress for the identified performance obligations. For example, the

manufacturer may conclude that an input measure such as the number of direct

labor hours incurred is the best measure of progress for the design services.




Illustration 6 — Measuring progress (continued)

For the aircraft, the manufacturer may determine that an output method, such

as units of delivery, is the best measure of progress for those performance

obligations. Alternatively, the manufacturer may determine that an input method

such as a “cost-to-cost” approach is the best measure of progress.

How we see it As illustrated in Scenario A above, the proposal may require entities in the A&D

industry to use an input method, such as a “cost-to-cost” approach, to best

depict the continuous transfer of goods and services. This could be a significant

change from current practice. Many entities today use a “units of delivery

method” (that is, an output method) to measure progress on contracts where an

output can be clearly identified. A “units of delivery” method may not be a

reasonable measure of an entity’s progress toward complete satisfaction of a

performance obligation in an arrangement where significant design services

have been bundled with production and delivery of tangible goods.

Bill-and-hold arrangements

Certain sales transactions may result in the entity fulfilling its obligations and billing

the customer for the work performed but not shipping the goods until a later date,

typically at the request of the customer due to a lack of storage capacity or delays

in the customer’s ability to use the goods.

Under the proposal, the entity would evaluate whether the customer has obtained

control of the goods to determine whether the performance obligation has been

satisfied and revenue should be recognized. Because the customer has not taken

possession of the goods, the proposal includes certain criteria for bill-and-hold

arrangements that are largely consistent with current US GAAP, but is slightly less

prescriptive. Specifically, the proposed guidance does not include the current US

GAAP requirements that the customer must request that the entity retain the

goods and that the arrangement must include a fixed delivery schedule.

Accordingly, we expect that most bill-and-hold arrangements that would qualify for

revenue recognition under current US GAAP would also qualify for revenue

recognition under the proposal.

Other measurement and recognition topics

Onerous performance obligations

The proposal requires an entity to recognize a liability and a corresponding expense

when certain performance obligations (that is, performance obligations satisfied

over time and that period is greater than one year) become onerous.

It is important to note that the proposal would require the measurement of a loss

for an onerous performance obligation at the performance obligation level rather

than at the contract level, as currently required by ASC 605-35. While some

entities would bundle the performance obligations in an arrangement into a single

unit of account, the proposal would represent a change from current practice for

entities that identify multiple performance obligations in an arrangement. Refer to

Section 7.2 in our general Technical Line for further discussion.




Variable or contingent fees

The 2010 ED proposed significantly changing current practice by requiring entities

to estimate the expected amount of award fees (and any other contingent fees) to

be received under the contract using a probability-weighted approach. Many

constituents raised concerns about this aspect of the proposal. As a result, the

Boards modified the proposal to require an estimate of the amount of variable

consideration to be made using either the “expected value” or the “most likely

amount” approach, whichever better predicts the ultimate consideration to which

the entity will be entitled. Each of these methods is discussed further in Section 4.1

of our general Technical Line.

The proposed guidance states that in applying either of the approaches, an entity

would consider all of the information (historical, current and forecasted) that is

reasonably available. While the Boards did not explicitly state this in the ED, they

appear to presume that an entity will always be able to estimate anticipated

amounts of variable consideration. Nonetheless, an entity would recognize variable

consideration only if it is “reasonably assured,” meaning that the entity has

experience with similar arrangements and the entity’s experience can be used to

predict the amount the entity will be entitled to in exchange for satisfying its


How we see it We believe that the proposed guidance on variable consideration would not

significantly change existing US GAAP for government contractors that apply

ASC 605-35. However, the proposed guidance represents a significant change

from the guidance in SAB Topic 13, which generally prohibits recognition of

variable amounts without objective evidence that such fees have been earned.

Contract costs

The proposal would provide guidance on the accounting for an entity’s costs

incurred in obtaining and fulfilling a contract to provide goods and services to

customers for both contracts obtained and contracts under negotiation. Costs of

obtaining a contact would be capitalized if they are incremental and expected to be

recovered under the contract.

Costs to fulfill a contract that do not qualify for capitalization in accordance with

other authoritative literature (such as ASC 330 on inventory, ASC 360 on property,

plant and equipment or ASC 985 on software) would be capitalized only if they

meet all of the following criteria:

• The costs relate directly to a contract or a specific anticipated contract, which

could include direct labor, direct materials, allocations of costs that relate

directly to the contract, costs that are explicitly chargeable to the customer

under the contract and other costs that were incurred only because the entity

entered into the contract (for example, subcontractor arrangements).

• The costs will generate or enhance resources that will be used in satisfying

performance obligations in the future.

• The costs are expected to be recovered.

The proposal would

require contractors to

estimate and recognize

variable consideration.




All other costs would be expensed as incurred, including costs of wasted materials,

labor or other resources to fulfill the contract that were not reflected in the price of

the contract.

Under ASC 605-35, government contractors generally capitalize certain indirect

costs within inventory. Under the proposal, we believe the indirect costs may

continue to be capitalized if they are explicitly chargeable to the customer or

represent the allocation of costs that relate directly to contract activities. Similarly,

we would not expect the proposed guidance to affect the treatment of pre-contract

costs that are determined to be recoverable.

Negative trends in estimated costs and margins for fixed-price contracts, however,

would be evaluated under the proposal to determine whether these are costs of

wasted materials that should be expensed as incurred. This would likely represent a

change from current practice because most entities include negative trends in total

estimated costs as long as the overall arrangement has sufficient margin to absorb

the cost increases.

Amortization of capitalized costs

The proposal would require costs capitalized in accordance with the guidance above

to be “amortized on a systematic basis consistent with the pattern of transfer of the

goods or services to which the asset relates.” The proposal says, however, that

certain capitalized costs may relate to multiple goods and services (for example,

design costs). For these costs, the amortization period could extend beyond a single

contract if the capitalized costs relate to goods or services being transferred under

multiple contracts, or if the entity expects the customer to continue to purchase

goods or services after the stated contract period.

Learning curve

Learning curve costs may include additional labor hours incurred and materials

consumed for the initial lots of new programs. In the A&D industry, the effect of

learning curves is often reflected in the transaction price of any long-term supply

arrangement and typically represents allowable costs under current federal

regulations for cost reimbursement.

Under the proposal, when an entity has a single performance obligation to deliver a

specified number of units or when the performance obligation is satisfied over time,

an entity would select a measure of progress that depicts the transfer of goods and

services to the customer. That is, an entity likely would select a method that

recognizes more revenue and more expense for the early units produced (e.g., a

“cost-to-cost” approach). This is appropriate because an entity would likely charge

a customer more if it had a contract to deliver only one unit.

However, when an entity’s promise to deliver a specified number of units is not

deemed to be a single performance obligation, those costs would have to be

accounted for under another standard (such as ASC 330 on inventory). That is, if a

performance obligation is not being satisfied over time, the entity likely is creating

an asset that would be in the scope of other standards. The Boards acknowledged

diversity in practice in the accounting for the costs of products produced under

long-term production programs, and agreed to consider adding a project to their

agenda at a future time.




Disclosures The ED proposes significant changes to existing disclosure requirements. The

Boards’ overall objective was to create disclosures that would enable users of the

financial statements to understand the “nature, amount, timing and uncertainty of

revenue and cash flows arising from contracts with customers.” The proposed

disclosures are both qualitative and quantitative in nature and would require

companies to discuss estimates and judgments at greater length in the notes to

their financial statements. Companies in the A&D industry may need to develop new

processes and systems to track the detailed information that would be required by

the proposal.

The ED does not provide implementation guidance or supplemental information on

the depth of disclosure required to fulfill the overall disclosure objective. Therefore,

companies likely would have to exercise significant judgment when preparing the

proposed disclosures.

Disaggregation of revenue

The proposal would require additional disclosure of disaggregated revenue on an

interim and annual basis and provides categories that may be appropriate to meet

the overall disclosure objective. The examples include the following:

• Type of goods or services

• Geography in which goods or services are sold

• Market or type of buyer, such as government versus private sector

• Type of contract, such as fixed-price, time-and-materials and cost-plus

• Duration of the contract

• Timing of transfer of the goods or services

• Sales channels

How we see it We believe A&D companies would use several of the categories proposed in the

ED because their contract type, contract duration and types of goods and

services vary significantly. For example, a company might provide heavy

machinery, software solutions and health care consulting services.

Satisfaction of performance obligations

For contracts with an original expected duration greater than one year, the

proposal would require a public entity to provide additional disclosure of the

transaction price allocated to remaining performance obligations and an

explanation of when the entity expects the amount(s) to be recognized as revenue.

The proposed disclosures can be provided quantitatively using “time bands” or with

a combination of qualitative and quantitative information. Refer to Illustration 8-3

in our general Technical Line for an example.

Complying with the

proposed disclosure

requirements could be

challenging for A&D

companies.




The ED also provides a practical expedient, which would allow an entity to omit

this disclosure requirement for cost reimbursable and time-and-materials contracts.

An example would be a services contract in which an entity has a right to invoice

the customer a fixed amount for each hour of service provided as specified in

the contract.

How we see it The proposed disclosure requirement would represent a significant change for

almost all A&D companies. The proposed requirement to disclose future

revenues and the expected timing of satisfaction of performance obligations

could require significant estimates to be made at a very granular level and then

aggregated into judgmental “time bands.” We believe that this proposed

disclosure, which would be required in the footnotes to the financial statements,

is similar to the current disclosure requirements in Management’s Discussion &

Analysis (MD&A) on backlog. However, the proposed disclosures would require

discussion about the forecasted realization and timing of that backlog. Given the

current diversity in practice on backlog calculations, we believe the proposed

disclosure would present a significant challenge for contractors.

Federal government contract accounting and compliance It is not possible to predict with certainty how the Cost Accounting Standards Board

(CASB) or the Federal Acquisition Regulation (FAR) Council, both of which govern

government contracting submissions, would react to any measurement differences

that may result from adopting the proposal. Government contractors that change

their methods of cost allocation based on the proposal would have to show that

such changes are preferable and consistent with Cost Accounting Standards (CAS).

However, there is substantial risk of negative or inconsistent government response

to any changes in allocation based on the proposal. Contractors should assess the

potential effect on contract accounting and consider discussing this with regulators

and contract oversight officials.

Regulatory framework

The US Government has developed increasingly detailed and complex rules about

acceptable costs (allowability) and methods of allocating those costs (allocability).

These rules are primarily contained in the FAR and CAS. As this regulatory

framework has evolved, regulatory authorities have often looked to GAAP in

developing policy. In some cases, however, they have determined that the

objectives of financial accounting and procurement policy (or national policy as

determined by Congress) are different. Consequently, differences currently exist

between the requirements of financial accounting and government contract

accounting. These accounting differences are typically addressed by using

memorandum records. Addressing these differences during a transition to the

proposed accounting could present challenges for regulators and contractors.

Changes to cost accounting practices under CAS

The methods adopted by a contractor to measure and allocate costs are defined as

cost accounting practices under the CAS. Before a contractor changes a cost

accounting practice, certain steps must be followed. If the change in cost

accounting practice is not required to comply with the CAS, contractors must notify




the government of the proposed change, provide an estimate of the cost impact

and negotiate any price or billing adjustments with the government. The allocation

of residual home office expenses in CAS 4032 is one example of a cost accounting

practice under the CAS that could be affected by adopting the proposal (because

revenue is one of the specified components in the three-factor formula used to

allocate costs). Whether the government will accept increased costs resulting from

a change depends on how the change is classified.

Contractors should carefully assess the potential effect of any changes to costs

resulting from the proposal to decide whether the need for the change outweighs

the adverse consequences if the change is processed as a unilateral change.

How we see it In determining whether to change their current cost accounting practices as a

result of the proposal, contractors would need to carefully assess the change

and determine whether it would be considered desirable. Contractors should

proactively address these issues.

Next steps • Entities in the A&D industry should apply the proposal to their common

transactions to identify any situations in which the accounting does not

appear to reflect the substance of a transaction and to identify potential

implementation issues, and communicate those issues to the Boards.

• Many preparers have expressed concerns about the proposed disclosure

requirements. We believe the Boards need detailed feedback from preparers

on the cost and benefits of preparing these disclosures and their overall

usefulness to users of the financial statements.

• Comments are due by 13 March 2012.

Endnotes:

1 ASC Subtopic 605-35, Revenue Recognition — Construction-Type and Production-Type Contracts 2 Cost Accounting Standard (CAS) 403, Allocation of Home Office (Headquarters) Expenses to Segments

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Technical Line: The revised revenue recognition proposal ... · Accounting Standards Codification. • Applying the proposal would require companies to evaluate performance obligations