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August 2012

October 8, 2012 To our clients and friends: After months of anticipation, the SEC completed its Staff report on the IFRS work plan. The Staff report did not include a recommendation on whether, when, or how IFRS should be i ncluded in the US financi al reporting system, and the Staff noted that a vast majority of participants in the US capital markets do not support outri ght adoption of IFRS by US issuers. However, the report did note that there was subs tantial support for exploring other methods of incorporating IFRS. Next s teps on this front are uncertain, but may lead to change further out i n the future. The FASB and IASB conti nue to work towards finalizing accounting standards on reve nue recognition, leasing and financi al instruments. Much of the focus was on the fi nancial instruments project this quarter, where the FASB changed course from the previous "three-bucket" impai rment model, as a result of i nput from US stakeholders. The FASB is still plans to issue an exposure draft by the end of the year. The boards have substantially completed their redeliberations on the leasing project and the proposals are expected to be reexpos ed in early 2013. Several important issues are still being addressed on the re-exposed revenue standard, with attention now focused on the variability, collectability and time value of money aspects of the new model. Barring any setbacks in these areas, a final standard is expected in the fi rst half of 2013. Companies shoul d remain engaged in the standard -setting process by participating in roundtables and comment letter processes. As standards change, compani es may need new systems that can capture data, track contracts, and s upport processes to develop and assess complex estimates. Inv estor and stakehol der communication and education may be necessary. The new standards will impact some compani es more than others, but all companies will need to thoughtfully consider them. We have been updating our compendium of our current convergence publications designed to provide you with one single reference resource as you manage the potenti al impact of the proposed standards on your company. Included is an overview of the s tandard -setting landscape, our perspective on the transition methods, and technical insights on the standard-setting projects. As developments unfolded and draft standards moved forward, we have pos ted updates for you to print and add to the original compendium on a dedicated website www.pwc.com/us/jointprojects. We will continue to do so, but in the meantime, if you have any questions, please reach out to your PwC engagement team or me directly.

Sincerely,

James G. Kaiser

James G. Kaiser, Partner, US Convergence & I FRS Leader PricewaterhouseCoopers LLP, Two Commerce Square, Suite 1700, 2001 Market Street, Philadelphia, PA 19103 T: (267) 330 2045, F: (813) 741 -7265, www.pwc.com/us/jointprojects

Contents
1. Setting the standard (March 2012) 2. SECTION: Effective dates and transition methods 3. In brief: IFRS Foundation responds to SEC's final report on IFRS "Work Plan" 4. Dataline: SEC Staff releases its final report on its IFRS Work Plan 5. In brief: SEC Staff releases final report on its IFRS Work Plan 6. Point of view: The path forward for international standards in the United States 7. SECTION: Financial

instruments 8. In brief: IASB proposes limited amendments to its financial instruments guidance under IFRS 9 9. In brief: FASB reaches conclusion on impairment model for financial assets measured at FV-OCI 10.In brief: FASB makes key decisions about the revised impairment model for financial assets 11. In brief: FASB decides to explore a revised impairment model for financial assets 12.In brief: FASB announces intent to further discuss key aspects of proposed impairment model 13.In brief: Boards agree on

three-category financial asset classification and measurement approach 14.In brief: FASB and IASB discuss a more converged financial instrument accounting approach 15.In brief: IASB delays IFRS 9 effective date 16.In brief: Let's try again - the impairment model for financial assets refined 17.Dataline: An update on the FASB's financial instruments project redeliberations as of June 30, 2011 18.Dataline: Accounting for hedging activities - A comparison of the proposed models

19.Dataline: Changes to financial instruments accounting impacts for nonfinancial services companies 20. SECTION: Revenue recognition 21.In brief: Boards conclude redeliberations on key revenue measurement and recognition issues 22.In brief: Boards make decisions on several major outstanding revenue issues 23.Dataline: Revenue from contracts with customers: The redeliberations continue 24.In brief: FASB and IASB decide on revenue contract modifications and measures of progress 25.In brief: FASB and IASB make

progress on revenue redeliberations; more to come 26.Dataline: Revenue from contracts with customers Ready, set, redeliberate 27.In brief: FASB and IASB redeliberate to make the proposed revenue standard less "onerous" 28. Dataline: Responses are in on the re-exposed proposed revenue standard 29.Dataline: Revenue from contracts with customers - The proposed revenue standard is re-exposed 30. 10Minutes on the future of revenue recognition 31.Revenue recognition: Aerospace industry supplement

32.Revenue recognition: Asset management industry supplement 33.Revenue recognition: Automotive industry supplement 34.Revenue recognition: Engineering and construction industry supplement 35.Revenue recognition: Entertainment and media industry supplement 36.Revenue recognition: Industrial products and manufacturing industry supplement 37.Revenue recognition: Pharmaceutical and life science industry supplement 38. Revenue recognition: Retail and consumer industry supplement

39.Revenue recognition: Transportation and logistics industry supplement 40. Revenue recognition: Technology industry supplement 41.Revenue recognition: Telecommunications industry supplement 42.SECTION: Leases 43.Dataline: Leases - One size does not fit all: A summary of the boards' redeliberations 44. In brief: Lease accounting deliberations come to an end, but alternative views are upcoming 45.In Brief: A dual model for lease accounting: redrawing the lines

46. In Brief: FASB and IASB deliberate lessee accounting May 2012 47.In brief: Can we talk about lessee accounting - again? 48. In brief: FASB and IASB make significant decisions related to lessor accounting and transition 49. In brief: Transition decision postponed - will this delay re-exposure of the Leases exposure draft? 50. In brief: FASB and IASB agree to re-expose leasing ED and agree on one lessor accounting model 51.Dataline: Redeliberations of the leasing project - Some new twists 52.In brief: Leases: FASB and IASB

change course 53.10Minutes on the future of lessee accounting 54.Dataline: A new approach to lease accounting - Proposed rules would have far reaching implications 55.SECTION: Fair value measurement 56.In brief: FASB clarifies scope of nonpublic entity fair value disclosure exemption 57.Dataline: Adoption of the new guidance: First quarter 2012 measurement and disclosure observations 58.Dataline: "New fair value measurement standard Adoption of the new guidance: First quarter 2012"

59.Dataline: Implementation guidance for new disclosure requirements 60. Dataline: New fair value measurement standard Implementation guidance for key changes 61.Dataline: Fair value measurement - FASB and IASB complete joint project 62.In brief: FASB and IASB issue final fair value guidance 63.SECTION: Statement of comprehensive income 64. In Brief: FASB to issue a revised proposal on reclassifications from other comprehensive income 65.Dataline: Presentation of comprehensive income -

Applying the FASB's final standard 66. SECTION: Balance sheet offsetting 67.In brief: FASB amends and clarifies scope of balance sheet offsetting disclosures 68. In brief: FASB issues final standard on balance sheet offsetting disclosures 69. In brief: FASB and IASB take separate paths on derivatives netting rules 70.SECTION: Pensions and postemployment benefits 71.In brief: FASB issues final standard to enhance disclosures for multiemployer pension plans

72.Dataline: Pension/OPEB accounting - Understanding changes expected from the IASB 73.In brief: IASB issues amendments to IAS 19, Employee benefits 74.SECTION: Insurance contracts 75.In Brief: FASB Chairman provides status update on insurance contracts project 76.Insurance contracts: Summary as of March 7, 2012 77.PwC summary of FASB education session - Insurance contracts (January 18 2012) 78.SECTION: Consolidation 79.In brief: IASB finalizes definition of an "investment entity"

80. In brief: IASB finalizes amendments to transition guidance for new consolidation standards 81.FASB and IASB agree on principles-based definition for investment companies 82. In brief: IASB proposes amending transition guidance for new consolidation standard 83. Dataline: FASB proposes to align investment company definition with IFRS proposal 84. Dataline: A look at the new IFRS consolidation standard and how it compares to US GAAP 85.In brief: IASB proposes accounting guidance for investment entities 86. SECTION: Financial instrument

presentation 87.Dataline: Financial Statement Presentation - A look at the FASB and IASB's Staff draft 88. SECTION: Contingencies 89. In brief: FASB votes to discontinue loss contingencies project 90. Dataline: Disclosure of Certain Loss Contingencies - An analysis of the FASB's proposed changes

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What you need to know about the FASB and IASBs joint projects

Setting the standard


A spotlight on the FASBs and IASBs projects

September 25, 2012

Whats inside
What you need to know. 2 Status of projects ........... 3 FASB/IASB projects: Financial instruments .......... 4 Revenue recognition............. 6 Leases .................................... 8 Insurance contracts ............ 10 Consolidation ....................... 12 Investment companies ........ 13 Other FASB-only projects .................... 15 Appendix: highlights of priority project board decisions .................. 21

What you need to know about the FASBs and IASBs standard setting activities
Welcome to the latest edition of Setting the standard, our publication designed to keep you informed about the standard-setting activities of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).

Progress continues, but is convergence closer?


What a difference a quarter makes. After a relatively slow second quarter, the boards made headway on their joint projects. Although progress has not been even, the boards are poised to issue several exposure drafts and final standards in the upcoming months. The financial instruments project occupied much of the boards' agenda during the quarter. While they were able to achieve greater convergence on classification and measurement, the boards appear to be parting ways on impairment. Both boards had been moving forward on a three bucket impairment model, but the FASB changed course based on input from US stakeholders. The FASB is now considering a different model it believes will be more operational. The FASB still plans to issue an exposure draft by the end of the year. On the other hand, the boards continue to make steady progress on redeliberations of their revenue recognition project. Although several important issues still need to be addressed, it appears we may see a final standard in the first half of 2013. And after many months of debate, the boards substantially completed redeliberations on the leases project. However, some board members have signaled their intent to provide alternative views in the upcoming exposure draft. Whether these views will impact the final standard remains to be seen. The boards plan to re-expose their proposals in early 2013.

FASB projects see continued momentum


As for FASB-only projects, the board had a very productive summer, issuing three exposure drafts and two discussion papers. In addition, the FASB released a final 1 standard to simplify indefinite-lived intangible asset impairment tests. There are plenty of important details and insights on these and other projects in this edition.

SEC staff weighs in on IFRS


In July, the Securities and Exchange Commission (SEC) staff issued its much 2 anticipated final report on its IFRS workplan. The SEC staff gave its commissioners plenty to think about in the 127-page report. Not surprisingly, one of the considerations the staff evaluated was the extent to which the FASB and IASB have achieved convergence on their joint projects. But what the report didnt include was a recommendation about whether, how, or when the US should incorporate IFRS. Those hoping for some direction are left with unanswered questions about the future of IFRS in the US. While timing of the SECs final decision is unknown, it will likely extend beyond 2012.

Refer to Dataline 2012-08, Indefinite-lived intangible asset impairmentFASB issues guidance that simplifies impairment test and allows early adoption. 2 Refer to Dataline 2012-06, SEC Staff releases its final report on its IFRS workplan.

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Setting the standard

Status of projects
Below is the FASBs project timeline. Key differences from the IASBs timeline are footnoted. Joint projects:
FI: classification and measurement FI: impairment FI: hedge accounting Revenue recognition Leases Insurance contracts Consolidation Investment companies

Q3 2012 R R R R D R (4) R

Q4 2012 ED (1) ED R (2)

H1 2013

Thereafter

F ED ED (3) F F R

FASB-only projects:
Investment property entities Liquidity and interest rate disclosures Liquidation basis of accounting Going concern Definition of a nonpublic entity Private company framework Disclosure framework Reclassifications out of accumulated OCI Repurchase agreements

C ED D DP (5) DP DP ED D

C ED C C C C ED

Legend:
D = Deliberations C = Comment period ends ED = Exposure draft issued/expected F = Final standard issued/expected R = Redeliberations DP = Discussion paper issued

(1) Although the IASB finalized its classification and measurement standard in October 2010, it is reconsidering certain aspects as it evaluates limited improvements and plans to propose amendments to its existing standard in the fourth quarter of 2012. (2) The FASBs timing for hedge accounting is uncertain. The IASB issued a review draft of its general hedge accounting standard in September, which is scheduled to be finalized in December. The IASB is expected to issue a discussion paper on macro hedging in 2013. (3) The FASB intends to issue an exposure draft in the fourth quarter of 2012. The IASB is considering re-exposure. (4) The timing of the FASB's final or re-exposed standard is uncertain. The IASB issued its consolidation standard in May 2011. (5) Tentative decisions reached about what constitutes a private company were exposed for comment as part of the July 2012 Discussion Paper on the Private Company Decision-Making Framework. The board still needs to address other aspects of this project, including not-for-profit organizations, and expects to issue a complete exposure draft once deliberations are finalized.

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Setting the standard

Financial instruments
Whats new?
The boards appear to be at a crossroads on an impairment model for financial assets. 3 After previously agreeing on a three bucket impairment model, the FASB decided to abandon that approach in favor of one it believes is more operational. It is unclear whether the IASB will move forward with its exposure draft on the three bucket model or if it will first consider the FASBs revised proposal. Meanwhile, the boards are in synch on much of their classification and measurement guidance, and the FASB anticipates releasing its revised proposal during the fourth quarter.

FASB takes a different direction on impairment


After considering the results of outreach and constituent feedback, the FASB concluded that aspects of the three bucket model are difficult to understand and present operational challenges that cannot be addressed through implementation guidance. As a result, the FASB decided to explore an alternative impairment model. FASBs alternative impairment approach The FASBs alternative approachknown as the current expected credit losses approachwill reflect managements estimate of the future contractual cash flows it does not expect to collect. The model will consider a range of potential outcomes, based on probability, resulting in an estimate of expected credit loss. There is no threshold that needs to be met before recording a credit impairment (for example, losses dont have to be probable), which is a key difference from both the three bucket model and current practice. Purchased credit impaired assets The FASB is attempting to simplify the accounting model for purchased credit impaired assets (that is, acquired assets that have experienced a significant credit deterioration since origination). Under the new model, an initial impairment allowance will be established based on expected losses that will be remeasured each period. Changes in the allowance, positive or negative, will be recognized in income immediately. This is expected to be less complex than existing guidance, where increases in expected cash flows are reflected prospectively through a yield adjustment.

A joint impairment model is proving difficult to achieve.

Boards reach additional classification and measurement decisions


Over the last couple of quarters, the boards reached general agreement on the accounting for debt investments. This was a major step toward convergence, with debt investments being classified in one of the following three categories: 1. Amortized cost 2. Fair value with changes in fair value recognized in other comprehensive income 3. Fair value with changes in fair value recognized in net income The boards tackled additional questions over the summer, including whether classification should be reconsidered if there is a significant change in an entitys business model for its investment portfolio. To demonstrate that a business model change is significant and warrants reclassification, all of the following criteria will need to be met:
3

The "three bucket" approach recognizes impairment in a way that reflects the general pattern of deterioration in the credit quality of financial assets. The level of reserves increases as credit deteriorates. Refer to In brief 2011-52, Let's try againThe impairment model for financial assets refined.

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Setting the standard

The change is determined by the entitys senior management in response to external or internal changes The change is significant to the entitys operations The change is demonstrable to external parties The boards, however, did not agree on when changes in a business model should be reported in the financial statements. The IASB requires changes to be reported at the beginning of the subsequent period after the change, whereas the FASB requires changes to be reported at the end of the period in which the changes occurred. The boards are not expected to further discuss the issue jointly.

The boards stay on course with classification and measurement decisions.

Classification and measurement The final stretch?


Beyond the joint decisions, the FASB is tying up loose ends on the remaining pieces of its model. While most of the big ticket items have been redeliberated, there are still key areas where differences remain between the FASBs and IASBs models: Accounting for equity investments not under the equity method of accounting Determining when the equity method of accounting can be used Accounting for hybrid instruments and convertible debt by issuers Determining when the fair value option should apply Presentation and disclosure requirements The FASB plans to discuss a number of these and other important issues in the coming months.

Whats next?
The FASB hopes to nail down key elements of its impairment model by the end of September and issue an exposure draft by the end of 2012. The FASB is also projecting an exposure draft on classification and measurement by the end of the year. Following these exposure drafts we expect the FASB to pick up its hedging project.

For more information: See a summary of key board decisions in the Appendix to this publication in addition to the following: In brief 2012-41, FASB reaches conclusion on impairment model for financial assets measured at FV-OCI In brief 2012-37, FASB makes key decisions about the revised impairment model for financial assets In brief 2012-10, FASB and IASB agree on a three-category financial asset classification and measurement approach Dataline 2011-06, Accounting for hedging activitiesA comparison of the FASBs and IASBs proposed models

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Setting the standard

Revenue recognition
Whats new?
Redeliberations are in full swing. The boards have been meeting to address key areas where stakeholders voiced concerns. Those concerns include how to determine when certain goods or services are distinct, how to apply the transfer of control criteria to service contracts, how to assess onerous contracts, and how to assess variable consideration when applying the reasonably assured constraint. The boards will be revisiting other important topics in the coming months as they move closer to finalizing this far-reaching new standard.

Redeliberations take two


During redeliberations, the boards have conducted extensive outreach, including sector-specific workshops and roundtables. With industry guidance going away, there is no shortage of application issues to address. But, rather than tailoring guidance for specific industries, the boards remain committed to evaluating issues on a broader basis. So far, the boards have: Refined the guidance for identifying separate performance obligations and determining when a performance obligation is distinct Clarified the criteria for performance obligations satisfied over time Eliminated the assessment of onerous performance obligations Agreed to clarify what constitutes variable consideration

License transactionsthe debate continues


Should license revenue be recognized upfront or over time? That has been a lingering question throughout the project. Recent focus on licensor-imposed restrictions (including time-based restrictions and restrictions on the customers use of the underlying intellectual property) has sharpened the debate. The boards expected to resolve this issue in July, but decided more work was needed. The staff will be taking another run at the issue, likely in October. The central question is whether these license restrictions impede transfer of control, and therefore, result in revenue recognition over time. Or, are the restrictions merely a characteristic of the asset being licensed, which should not delay upfront revenue recognition. Throughout this debate, the software and entertainment industries have been particularly engaged. But licenses of intellectual property are common in other industries as well. The boards continue to analyze the guidance in this area, so stay tuned.

Where do redeliberations stand?


The boards upcoming meetings will focus on the treatment of customer credit risk, the time value of money concepts, and other broader issues. Heres a recap of some of the key decisions made so far this year:
Topic Identifying separate performance obligations Key redeliberation decisions Clarified that a promised good or service is a separate performance obligation if it is capable of being distinct (i.e., customers ability to benefit separately from the good or service) and is distinct in the context of the contract (i.e., customers

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Setting the standard

Topic

Key redeliberation decisions perspective of what they have contracted to receive) Added indicators to assess whether goods and services are distinct in the context of the contract Added an indicator to help determine the performance obligations for repetitive service contracts Considered one performance obligation if it is satisfied over time and the same measure of progress is used to depict transfer to the customer

Performance obligations satisfied over time Onerous contract loss test Reasonably assured constraint

Clarified and refined the criteria to determine recognition over time to better address application to service contracts Clarified the guidance about whether an asset has an alternative use and when an entity has a right to payment for performance to date Removed the requirement to assess onerous performance obligations Retained existing guidance in both US GAAP and IFRS regarding contract losses Removed the term reasonably assured in favor of an objective to include amounts for which the entity has predictive experience Agreed to clarify what constitutes variable consideration

Whats next?

The boards goal is to issue a final standard in the first half of 2013. To do that, they will need to stay on pace with their plans to address a number of significant issues in the coming months. Several of the more hotly contested issues have yet to be addressed including transition, disclosures, and effective date.

For more information: In brief 2012-28, FASB and IASB redeliberate to make the proposed revenue standard less "onerous" Dataline 2012-07, Revenue from contracts with customersReady, set, redeliberate Dataline 2012-04, Responses are in on the re-exposed proposed revenue standardConstituents voice their support and concerns Dataline 2011-35, Revenue from contracts with customersThe proposed revenue standard is re-exposed (includes certain industry supplements) 10Minutes on the future of revenue recognition

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Setting the standard

Leases
Whats new?
After nearly 18 months of debate, the boards substantially completed leasing redeliberations in July. The boards agreed to a dual approach that both lessees and lessors will apply to determine income statement recognition. Now, the staff is working through the difficult task of writing an exposure draft for another round of public input, expected early next year. The next stage of this project may be interesting to watch as several FASB and IASB members voiced significant concerns about key elements of the revised proposals. These concerns are likely to be discussed further before a final standard is issued.

The dual approach


To recap, the boards voted for a dual approach for lessee accounting, allowing straight-line expense recognition for some leases. Other leases will follow an interest and amortization approach with a front-loaded expense recognition pattern (similar to that proposed in the 2010 exposure draft). Under either model, all leases will be recognized on the balance sheet unless the maximum lease term is 12 months or less. Classification of a lease will be based on a principle of consumption of the underlying asset. That is, a lease will be classified using either the interest and amortization approach or a single lease expense approach, depending on whether the asset is consumed over the lease term. Generally, lessees will recognize expense on a straight-line basis for leases of property (buildings and land). The accounting for other types of leases, such as equipment, generally will follow the interest and amortization approach, resulting in front-loaded expense. These presumptions can be overcome in certain circumstances. Lessor accounting will also incorporate a consumption model depending on whether the lease term is for a major part of the assets economic life or the present value of the fixed lease payments account for substantially all of the leased assets fair value. Its likely that most lessors of property will continue to qualify for an approach similar to todays operating lease accounting , recognizing income on a straight-line basis over the lease term. For leases of assets other than property, lessors will apply the receivable and residual approach if the lessor has sold more than an insignificant portion of the underlying asset. Under this approach, a lessor will recognize upfront profit and a receivable for the portion of the asset sold. For the portion of the asset deemed not sold, a lessor will recognize a residual asset and no upfront profit. Leases of equipment will likely qualify for this approach. The boards decision to incorporate a dual approach overturns the previous scope exclusion for investment property. The scope exclusion is no longer needed because application of the consumption of the underlying asset principle results in most lessors of investment property applying an approach similar to existing operating lease accounting, rather than a receivable and residual approach.

Alternative views may lead to future redeliberations.

Alternative views looming


Redeliberations have been a challenge for the boards, as they try to balance comments from preparers and users. Preparers have concerns about the cost and complexity of applying the requirements, while users continue to challenge the usefulness of information provided by the proposals. Other concerns also surfaced during redeliberations about the conceptual merit and practical application of the proposed model.

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Setting the standard

In fact, several FASB and IASB members may present alternative views in the revised exposure draft. Some FASB members expressed significant concerns about the overall cost/benefit proposition and questioned whether the proposal will provide users with more useful information. Other concerns raised include the accounting for variable leases payments, the effectiveness of disclosures, and the interaction of lessor accounting with the proposed revenue recognition model. Some IASB members also may present alternative views indicating support for a single, rather than dual, lease accounting model by both lessees and lessors.

Whats next?
The FASB is scheduled to meet soon to discuss potential differences for nonpublic entities. An exposure draft is expected in early 2013, with a 120-day comment period.

For more information: See a summary of key board decisions in the Appendix to this publication. Dataline 2012-11, Leases One size does not fit all: A summary of the boards' redeliberations In brief 2012-26, Lease accounting redeliberations come to an end, but alternative views are on the horizon In brief 2012-15, A dual model for lease accounting: redrawing the lines

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Setting the standard

Insurance contracts
Whats new?
A converged solution on insurance contracts may not be likely, but the boards are still jointly deliberating some topics. The FASB continues to make progress toward its plan to issue an exposure draft. The board recently decided charitable gift annuities will not be in scope of the project, but title insurance will. The FASB also decided all advertising, including direct response, will be expensed as incurred. In addition, the FASB recently made an important decision on its single margin approach, and the boards made a much awaited joint decision on transition. The weighty topic of income statement presentation still needs to be addressed.

Single margin to lock or unlock?


Under the FASBs building block model, a deferred profit (single margin) is recognized at inception if expected cash inflows exceed expected cash outflows. The margin is then amortized in future periods as the insurer satisfies its obligation to policyholders, based on the insurers release from risk. The FASB decided that the single margin on a portfolio of insurance contracts will not be used as an offset (unlocked) for changes in actual or expected cash flows. Instead, changes in cash flows will be reported in the income statement immediately. The FASB believes this approach most faithfully represents the current value model. The board decided that changes in management expectations of cash flows should be recognized in the income statement when they occur, rather than spreading the impact over future periods. This differs from the IASBs view on its residual margin, which will be adjusted for changes in cash flow estimates. An exception to the FASB's lock-in of margin approach occurs if an insurer determines that a portfolio of contracts is onerous (that is, in an overall loss position). In that case, an additional liability will be recognized with a corresponding offset that eliminates any remaining margin. If that additional liability exceeds the remaining margin, an insurer will recognize an expense for the excess. This is similar to todays treatment for traditional long duration contracts, where the policy benefit liability calculation is locked in unless there is a premium deficiency. Despite the FASBs rationale, some constituents prefer the approach of adjusting the margin for changes in estimates. They argue that if expected cash outflows increase, the contract becomes less profitable. In that case, they believe locking in the single margin amortization amount based on an amount determined at contract inception is inconsistent with a current value model.

Convergence may not be in the cards, but the boards continue to jointly discuss some issues.

Transition boards land on retrospective


In September, the boards decided that their proposals should be retrospectively applied to all prior periods. Such an approach will require a retrospective determination of the residual margin (IASB) or single margin (FASB) back to contract inception, which could be quite a challenge for many life insurance companies. Even if full retrospective application is not practical, other methods of estimation must be employed. A practical expedient is also expected for determining the applicable discount rate.

Exclude investment components from premiums and claims


For the most part, investment components of an insurance contract will not be unbundled and measured as financial instruments. Instead, they will be included in the measurement of the insurance liability. However, the boards decided that the investment component of insurance premiums received, and subsequently, of claims paid, will not be included in premium revenue or claims expense, respectively, in the
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income statement. Next, the FASB plans to discuss how to determine the investment component. We expect the board to debate several alternatives in October.

Income statement presentation still looking for an answer


We expect the boards to continue discussing income statement presentation of key items such as premiums, claims, benefits, and gross underwriting margin in October. The insurance industry and financial statement users overwhelmingly oppose the summarized margin approach originally proposed. Instead, they support presenting theses items individually in the income statement. After much discussion and debate, the issue of presentation remains unresolved. Whether a classic revenue and expense presentation can be created from a balance sheet approach (that focuses on current value measurement) is yet to be determined.

Whats next?
The FASB is still targeting the end of 2012 for an exposure draft, but that could be delayed to 2013 given the significant topics still to be discussed. Additionally, the FASB has yet to decide whether it will target specific changes to existing US GAAP or issue an entirely new standard. The IASB, on the other hand, will ultimately issue a comprehensive insurance standard.

For more information: See a summary of key board decisions in the Appendix to this publication. In brief 2012-14, FASB chairman provides status update on insurance contracts project IASB-FASB insurance contracts project summary (as of April 19, 2012) Dataline 2011-14, (revised March 4, 2011), Insurance contractsComment letter themes being addressed in fast paced redeliberations Dataline 2010-39 (revised February 16, 2011), Insurance contracts Fundamental accounting changes proposed

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Setting the standard 11

Consolidation
Whats new?
Keep the consolidation project on your watch list. There may be some news coming later this year as the FASB continues to make decisions that could change which entities are considered variable interest entities, and who, if anyone, should consolidate. After appearing to be on the backburner for several months, this project has recently come back into focus. The FASB listened to feedback and is considering whether to change aspects of the proposal it issued last year. Discussions will likely continue in the fourth quarter as the board works toward issuing a final standard in the first half of 2013.

What did the proposal say?


As a reminder, the proposal introduces a principal versus agent model to determine whether an entity is a variable interest entity and who should consolidate a variable interest entity, and to determine if a general partner should consolidate a limited partnership or similar entity. A decision-maker that is a principal will typically consolidate while an agent will not. Three factors will be weighted in performing this analysis: (1) the rights held by other parties, (2) the decision maker's compensation, and (3) other economic interests held by the decision maker.

Redeliberation decisions reached to date


The FASBs redeliberations are still in the early stages. Perhaps most noteworthy is the boards decision to reaffirm its intent to align the guidance for participating rights across all consolidation models. This will impact entities beyond variable interest entities, and could trigger changes to todays conclusions about whether to consolidate. For example, under the current consolidation approach for voting entities, a noncontrolling shareholders ability to veto decisions about a specific activity could prevent a majority shareholder from consolidating an entity. Under the proposal, a noncontrolling shareholder must be able to veto all of the activities that most significantly impact the entitys economic performance before the majority shareholder will be precluded from consolidating.

Whats next?
The FASB will next discuss important implementation guidance about how to weigh the three factors in a principal vs. agent analysis. The timetable for a final standard has slipped into the first half of next year. Companies will want to stay on top of developments because if this proposal moves forward, it could significantly change current practice. For more information: In brief 2012-20, IASB finalizes amendments to transition guidance for new consolidation standards Dataline 2011-33, Consolidation of VIEs and partnershipsmore changes under considerationFASB proposes to require principal versus agent analysis Dataline 2011-29, (revised November 15, 2011), A look at the new IFRS consolidation standard and how it compares to US GAAPMany aspects of the IASBs consolidation guidance are now converged with US GAAP

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Setting the standard 12

Investment companies
Whats new?
The boards have continued redeliberations and are nearing completion of their joint project. In response to feedback, the boards revised their original proposal, which had defined an investment company using six prescriptive criteria. While retaining some of the original requirements, the revised approach will allow for more judgment. The new model defines an investment company using certain criteria, but also incorporates additional, non-determinative characteristics of a typical investment company. These include whether an entity manages its investments on a fair value basis; its number of investments and investors; related party investors; and ownership interests. Interestingly, this means an entity could qualify as an investment company even if one or more of the typical characteristics of an investment company are not present.

FASB sharpens its guidance on investee funds


On the consolidation front, the FASB decided to retain existing guidance for consolidation of investee funds. It also identified certain disclosures that will be required for significant investments in an investee fund. Further, the FASB clarified that any investment that is held by an investee fund that is significant to the reporting entity will need to be disclosed. This will change current practice, which requires disclosure of the underlying investments that exceed 5% of the reporting entitys net assets.

The boards decided to change the proposed definition of an investment company, allowing for more judgment in the evaluation.

The definition of an investment company


The FASB reaffirmed its earlier decision that entities regulated under the SECs Investment Company Act of 1940 will continue to qualify as investment companies for accounting purposes irrespective of whether they meet the investment company definition. As a result, certain entities such as business development corporations that may not qualify based on the proposed criteria will continue to report using an investment company model, consistent with their regulatory reporting requirements.

Convergence differences may remain


Generally, constituents have welcomed the new principles-based approach, although some significant differences remain between the two boards proposals. The IASB continues to view investment company accounting as a narrow exception to consolidation or equity method accounting. However, the FASB believes the definition of an investment company should be applied more broadly. The differing approaches proposed by the boards means that entities with similar activities for example, entities holding debt securities primarily for collection of income streams could reach different conclusions about whether they meet the definition of an investment company under IFRS and US GAAP. Despite these differences, its safe to say that many view the boards new approach as much closer to the existing investment company definition than the rules-based approach previously proposed.

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Setting the standard 13

Whats next?
The IASB appears to have finalized its decisions on most matters and is expected to issue a final standard in the upcoming months. While the FASB will continue deliberating some key topics, such as effective date and transition, it still plans to issue a final standard on this project by the end of 2012.

For more information: In brief 2012-12, FASB and IASB agree to principles-based definition for investment companies Dataline 2011-32, Investing in a new investment company definition FASB proposes to align investment company definition with IFRS proposal

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Setting the standard 14

Other FASB-only projects


Outside the joint projects, the FASB continues to work on various projects that impact US GAAP. Highlights of these are included here. During the quarter, the FASB discontinued its loss contingencies project and its nonpublic entity fair value measurement disclosures project.

Investment property entities still searching for a solution


Companies holding investment property are following this project closely, as it may impact how their investments are measured. Although the original proposal had centered on an entity-based model, the FASB abandoned that approach and is now considering other options. One of those options may be to simply discontinue the project. Another possibility is to develop asset-based guidance. The prospect of asset-based guidance generated significant discussion at the August board meeting, but concerns emerged about the boards ability to define investment property and whether such guidance should include a requirement, or an option, to measure investment property at fair value. At this point, it is unclear if convergence will be achieved. Under IFRS, entities have the option to measure all investment properties at fair value. At previous meetings, the FASB also considered integrating certain aspects of this project (such as presentation and disclosure matters specific to real estate funds) into the investment companies project. One obstacle to this approach is that the investment companies project is a joint project with the IASB, while the investment property entities project is a FASB-only project. Thus, merging these two projects does not appear likely. For its next steps, the board plans to evaluate the asset-based approach in conjunction with its research project that is focused on when a reporting entity should apply asset- or entity-based guidance to its nonfinancial assets. A preliminary report is expected in the fourth quarter. For more information: In brief 2012-34, FASB debates the path forward for investment property entities Dataline 2011-34, Investment property entitiesThe good, the bad and the ugly

Risk disclosures proposal comment letter period wraps up


In June, the FASB released a proposal that will require new disclosures about liquidity and interest rate risks. The proposal introduces new quantitative and qualitative liquidity risk disclosures for all entities. For financial institutions, the proposal goes further. It requires more extensive liquidity disclosures and interest rate risk disclosures. As defined in the proposal, financial institutions are entities and reportable segments that earn income primarily from managing the difference between interest generated on financial assets and interest paid on financial liabilities, or that provide insurance. Breaking it down, most banking entities or segments will likely fall within the definition, while investment banks, broker-dealers, and investment companies will not.

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The FASB did not propose an effective date but would like it to be soon. See the Appendix to this document for additional details on the types of disclosures proposed. The comment period ended September 25, 2012. For more information: Dataline 2012-12, Disclosures about liquidity risk and interest rate risk A closer look at the proposed standard

Liquidation basis of accounting striving for consistency and comparability


The FASB recently issued an exposure draft on the liquidation basis of accounting. Today, there is minimal guidance about when and how an entity should apply the liquidation basis of accounting. IFRS does not provide guidance in this area. The proposal requires an entity to prepare its financial statements using the liquidation basis of accounting when liquidation is imminent. Liquidation is imminent when either: the plan of liquidation has been approved by the entitys governing body that has the power to make such a plan effective and it is remote that the plan will be blocked by other parties, or the plan to liquidate is being imposed by other forces and it is remote that the entity will return from liquidation in the future. Assets and liabilities will be measured at the amounts expected to be collected or paid during the course of liquidation. An entity will accrue and present costs it expects to incur and income it expects to earn during the liquidation period. Statements of net assets in liquidation and of changes in net assets in liquidation will continue to be required, along with disclosures about the liquidation plan and amounts recorded. The board has not yet proposed an effective date. Comments are due by October 1, and a final standard is expected in late 2012 or early 2013. For more information: In brief 2012-22, FASB proposes guidance for applying liquidation basis of accounting

Going concern FASB taking another look


After a few starts and stops, the board is now recommencing deliberations on its going concern project. Some believe management needs to disclose more about the ability of its company to stay in business, but thats a thorny issue. The questions at hand are whether and how an entity should conduct a going concern assessment and if so, what should be disclosed. Expect to see some updates in the fourth quarter.

Private company decision-making framework taking steps forward


With the members of the new Private Company Council (PCC) now appointed and the FASB getting input on a decision-making framework, progress is well underway toward addressing private company financial reporting. In July, the FASB issued a discussion paper on a framework that the FASB and the PCC will use in determining

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Setting the standard 16

whether and when to allow exceptions or modifications to US GAAP for private companies. The purpose of the framework is to better address the needs of private company financial statement users and identify opportunities to reduce the complexity and cost of preparing financial statements. The framework asserts that lenders and investors often use private company financial statements differently than public company users, and they sometimes need different information. It also calls for a deeper cost-benefit evaluation, given the typical resource constraints of private companies. In a separate but concurrent project, the board is making important decisions about which types of companies qualify as nonpublic entities and which entities can apply the differences allowed under the framework. The discussion paper includes the boards tentative decisions and the FASB is seeking input about whether there are additional types of entities that should be included in the definition. The paper includes initial FASB staff recommendations but reflects input from the board and a variety of private company stakeholders. The paper identifies the following six significant factors that differentiate private company financial reporting from that of public companies: Types and number of financial statement users Access to management Investment strategies Ownership and capital structures Accounting resources Learning about new financial reporting guidance The paper also provides a look into the factors to consider when allowing differences in recognition and measurement, disclosures, display (presentation), effective dates, and transition methods. The board has not deliberated any of the topics in the staff paper or reached tentative conclusions about the framework. This is because much of its content breaks new ground, so the FASB first wants to hear whether its on the right track. Also, comment letter input should be ready to share with the PCC, which is tasked with jointly approving the framework. The question that remains top of mind for many stakeholders is to what extent the board and PCC should allow differences in recognition and measurement between private and public companies. Those favoring a single or pure set of US GAAP are hopeful differences will be minimal, while others want to see more significant changes. Another key issue the board and PCC will need to tackle is whether a private company that elects to apply any difference in recognition or measurement guidance must apply all differences available, or whether it should be able to pick and choose. While these initiatives are aimed at private companies, we see the benefits of the framework extending beyond private companies. Thats because any cost-effective alternatives identified to benefit private companies might also influence the FASBs public company and not-for-profit organization standard-setting activities.

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Setting the standard 17

The comment period ends October 31, 2012 and the FASB is hopeful many stakeholders will weigh in.

Disclosure framework a cure for disclosure overload?


The FASB issued a discussion paper in July seeking stakeholder input on ways to improve disclosure effectiveness. With preparers upset about prescriptive and lengthy disclosure requirements, and users frustrated that notes have become too boilerplate, the board sees the need for change. The FASB is hopeful the project will reduce the volume of disclosures, but says this is not its primary objective. The paper does not propose any specific changes but it does suggest a number of concepts and alternatives that the FASB believes could lead to better disclosures. At the projects core is how to clearly communicate information that users find most important to their decision-making. The paper discusses a decision process that the FASB could use to establish disclosure requirements intended to provide the most relevant information to users. And recognizing that one size doesnt fit all, the FASB suggests that the decision process could also be used by management to decide on the appropriate type and level of disclosures. In doing so, the FASB has introduced an approach that could empower management to exercise judgment in determining the extent of disclosure to provide based on their circumstances. The paper suggests the following four methods to create flexible disclosure requirements designed to focus on information that is relevant: Change disclosure requirements to be less prescriptive Provide one set of disclosures and require preparers to determine which are relevant Provide minimum and expanded disclosures for each topic and require preparers to choose between these two alternatives Provide three or more tiers (instead of just a minimum and a maximum) and require preparers to decide which tier to apply The paper also includes details of the following: A judgment and materiality framework that preparers could use to determine which disclosures are relevant in specific circumstances Organization and formatting techniques that could make the information users need easier to find and understand Disclosure requirement alternatives for interim financial reporting After the framework has been sufficiently developed, the board plans to apply it to both new and existing standards. The comment period ends November 16, 2012. For more information: Dataline 2012-09, FASB solicits feedback on its framework for improving financial statement disclosures

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Setting the standard 18

Reclassifications out of accumulated OCI responding to stakeholder concerns


In August, the FASB issued an exposure draft that will require companies to disclose information about reclassifications from accumulated other comprehensive income (OCI) to net income in their interim and annual financial statements. The new guidance responds to concerns raised about the amendments issued in 2011 relating to the presentation of OCI. The 2011 amendments required entities to measure and present the effect, by individual line items within net income, of reclassifications from accumulated OCI on the face of the financial statements. Preparers said it was too difficult to identify the income statement line items affected by reclassifications from accumulated OCI when those amounts are first reclassified to a balance sheet account. On top of that, some stakeholders felt that the original requirement to present reclassifications on the face of the financial statements would cause clutter and distraction. The FASB listened and believes its new proposal strikes the right balance by addressing the concerns of financial statement preparers while still providing the additional transparency sought by financial statement users. Under the proposal, companies must disclose, in a single footnote, a table showing the amount reclassified from each component of accumulated OCI and the income statement line items affected by the reclassification. The income statement line item will only need to be shown for components required to be reclassified to net income in their entirety. This means that for items reclassified from accumulated OCI that are capitalized, such as net periodic pension costs, affected line items will not be disclosed. However, companies will need to cross reference to the footnote where additional information can be found (for example, the pension note). The FASB did not propose an effective date, but the final standard could be effective for public companies as early as 2012, with a one-year deferral for private companies. The comment period ends October 15, 2012. For more information: Dataline 2012-13, Disclosure of items reclassified from accumulated other comprehensive income FASB proposes new disclosures

Repurchase agreements stay tuned for proposal


The FASB recently decided to require certain types of transactions, including certain repurchase agreements, to be accounted for as secured borrowings. As a refresher, repurchase agreements (or repos) involve the transfer of a financial asset and an agreement for the transferor to repurchase the transferred asset or a similar asset from the transferee in the future. Currently, repurchase transactions are accounted for either as: Financing transactions the transferred asset remains on the balance sheet of the transferor and cash received by the transferor is treated as a secured borrowing Sales the transferred asset is derecognized or removed from the balance sheet of the transferor, cash received is treated as sale proceeds, and the obligation to repurchase the transferred asset generally is treated as a derivative

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Setting the standard 19

Feedback suggests that constituents generally view repurchase agreements as financing transactions. The FASB decided that specifying the types of transactions to be accounted for as secured borrowings would expeditiously address this feedback and achieve greater consistency. The board decided that a repurchase agreement or similar transaction that meets all of the following six criteria will be accounted for as a secured borrowing: It involves a transfer of existing financial assets at its inception It involves both a right and an obligation to repurchase financial assets The initial transfer and forward repurchase agreement involve the same counterparty The agreement to repurchase the financial assets is entered into contemporaneously, or in contemplation of, the initial transfer The repurchase price is fixed or readily determinable The financial assets specified under the forward repurchase agreement are identical to or substantially the same as the financial assets transferred at inception The FASB decided to utilize the existing criteria defining substantially the same and make minor modifications to reinforce that a company needs to do a full analysis to conclude about the substantially the same criteria. For repurchase agreements that do not meet all of the criteria above, the transaction will be evaluated under the existing derecognition criteria. This includes analysis of legal isolation, the transferees ability to freely pledge or exchange the transferred asset, and whether the transferor maintains effective control. In addition, the FASB decided to require additional quantitative disclosures for both transactions accounted for as secured borrowings and those accounted for as sales. Expect an exposure draft to be issued before the end of the year. For more information: In brief 2012-42, FASB determines additional disclosure requirements for repurchase agreements In brief 2012-33, FASB makes further decisions on repurchase agreement accounting In brief 2012-19, FASB tentatively agrees on approach for repurchase agreement accounting

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Setting the standard 20

Appendix: highlights of priority project board decisions


Financial instruments: summary of FASB decisions on classification and measurement to date
Component Current proposal Financial assets will be classified into one of three categories based on: (1) the individual instruments characteristics and (2) an entitys business strategy for the portfolio. The basis for classifying financial liabilities is expected to be discussed further by the board. Classified into one of the following categories: amortized cost, Debt investments fair value with changes in fair value recognized in other comprehensive income, or fair value with changes in fair value recognized in net income. Debt liabilities Classified into one of the following categories: (1) amortized cost; or (2) fair value with changes in fair value recognized in net income. Classified as fair value with changes in fair value recognized in net income. A practicability exception is allowed for measuring nonmarketable equity securities. Applicable if there is significant influence over the investee, but only if the investment is not held for sale. If held for sale, equity investment accounting applies (that is, fair value). Separate accounting for financial asset host contracts and embedded derivatives in hybrid financial assets will be prohibited; instead, the entire hybrid financial asset is accounted for as a single instrument. Hybrid financial liabilities will continue to be bifurcated. Only available for: Fair value option hybrid financial liabilities, to avoid the complexity of separately accounting for embedded derivatives, and groups of assets and liabilities managed and reported on a net exposure basis. Fair value will be presented parenthetically on the face of the balance sheet for financial assets measured at amortized cost. Amortized cost will be presented parenthetically on the face of the balance sheet for financial liabilities recorded at fair value (such as debt), excluding demand deposits.

Principle for classification

Equity investments (not under the equity method of accounting)

Equity method of accounting

Hybrid financial instruments

Presentation

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Setting the standard 21

Financial instruments: summary of IASB decisions on impairment to date (see next page for FASB decisions to date)
Component Current IASB proposal Impairment of financial assets will follow a threebucket approach. All assets originated or purchased with no credit deterioration will start in bucket one and move into bucket two or bucket three as credit quality deteriorates. Estimates of lifetime losses must: Estimating expected losses reflect all reasonable and supportable information considered relevant consider a range of possible outcomes consider the time value of money Assets with evidence of credit deterioration at acquisition will begin in either bucket two or bucket three and remain outside of bucket one even if credit subsequently improves. Interest income will be measured based on expected future cash flows, which is continually updated to reflect current estimates. An expected loss impairment model is applied to trade receivables with a significant financing element. Entities can either apply the general approach or a simplified approach in which the allowance is based on lifetime expected losses at initial recognition. An expected loss impairment model will be applied to trade receivables without a significant financing component. Measurement objective is a lifetime of expected losses. For lease receivables, entities can either fully apply the general approach or a simplified approach in which the allowance is based on lifetime expected losses at initial recognition. For debt instruments modified in a troubled debt restructuring, an entity will recognize lifetime expected credit losses.

The general approach

Purchased credit impaired assets

Trade receivables with a significant financing component

Trade receivables without a significant financing component

Lease receivables

Troubled debt restructurings

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Setting the standard 22

Financial instruments: summary of FASB decisions on impairment to date


Component Current FASB proposal Impairment of financial assets will follow current expected credit loss (CECL) approach. Expected losses are defined as the estimate of contractual cash flows not expected to be collected. There will be no threshold to meet prior to recording expected credit losses. Estimates of lifetime losses must consider: Estimating expected losses all relevant, reasonable, and supportable information a range of possible outcomes the time value of money These are assets acquired that have experienced significant credit deterioration since origination. Purchased credit impaired assets The initial impairment allowance will be based on the level of expected losses. The impairment allowance is updated each period with changes to be recognized in income immediately. The remaining non-credit purchase discount or premium is recognized in income over the life of the asset.

The general approach

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Setting the standard 23

Financial instruments: summary of FASB decisions on liquidity and interest rate disclosures to date
Non-financial institutions Financial institutions

Qualitative disclosures

Additional discussion and numerical information about significant changes in the timing and amounts included in quantitative tables is required where needed to provide users an understanding of the entity's risk exposure. Available liquid funds table: shows unencumbered cash and high-quality liquid assets currently held, and available sources of borrowings (e.g., lines of credit) Expected cash flow obligations table: shows the undiscounted amount and timing for all obligations, including off-balance-sheet items Not applicable Available liquid funds table: same as non-financial institutions

Quantitative liquidity risk disclosures

Expected maturity table: shows amount and timing of expected settlement for all financial assets and liabilities based on contractual terms Repricing analysis table: shows timing of when interest rates will be reset on classes of interest-bearing financial assets and liabilities Interest rate sensitivity table: shows impact on net income and equity of prospective, hypothetical interest rate shifts on an entitys interestsensitive financial assets and liabilities Time deposits table (for depository institutions only): shows total amount, average interest rate, and life for issuances of classes of time deposits for the previous four quarters

Quantitative interest rate risk disclosures

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Setting the standard 24

Appendix, continued
Revenue recognition: summary of joint board decisions to date
Component Current proposal Applicable to all industries and entities. Contracts scoped out: Financial instruments Scope Insurance contracts Lease contracts Guarantees (excluding warranties) Certain nonmonetary exchanges Considered a separate contract and accounted for prospectively if the modification results in the addition of a separate performance obligation and price is reflective of stand-alone selling price of the additional obligation. Otherwise accounted for as an adjustment to the original contract either through a cumulative catch-up adjustment or prospective adjustment as future performance obligations are satisfied. Separate performance obligations exist if the goods or services are: Identifying separate performance obligations capable of being distinct because the customer can use the good or service on its own or together with resources readily available to the customer, and distinct in the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract. An entity will combine a good or service with other goods or services in the contract if they are not individually separable until a separate performance obligation is identified. Includes fixed and variable consideration with variable consideration at a probability-weighted estimate or most likely amount of cash flows, whichever is most predictive. Time value of money will be included when significant and if it exceeds a period greater than one year. Bad debts will not be included; rather, they will be reflected in a line item adjacent to revenue (not as an expense). Allocation of transaction price to multiple performance obligations Based on relative selling price of all performance obligations. Residual technique can be used when the standalone selling price of a good or service is highly variable or uncertain. Variable consideration and discounts can be allocated to one (or more) performance obligations in some cases. Goods and licenses: when control passes. Timing of revenue recognition Services: as the obligation is being satisfied, if specified criteria are met. Otherwise, upon completion of the service. Constrained to amounts for which the entity has predictive experience. Customer options Only considered a separate performance obligation if the option provides the customer a material right (for example, a discount incremental to the range of discounts typically given to similar customers in similar markets).

Contract modifications

Elements of the transaction price

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Setting the standard 25

Component

Current proposal Recognize revenue allocated to the option when the option expires or when the additional goods or services are transferred. Accounted for as a separate performance obligation if the customer has the ability to purchase it separately. Considered a cost accrual if not sold separately unless a service is provided in addition to the standard warranty. Generally consistent with existing guidance. Derecognize the full value of inventory, record a liability for the refund obligation, and recognize an asset representing the right to recover goods. Revenue recognition will be precluded when an entity is unable to estimate returns.

Warranties

Rights of return

Onerous contract losses

Retains existing guidance in US GAAP and IFRS to assess whether a contract is onerous. Incremental costs of obtaining a contract will be capitalized if expected to be recovered. Entities can choose not to apply to short-term contracts (12 months or less). Assets will be amortized over the expected period of benefit, which may exceed the contract term. Costs to fulfill a contract will be capitalized based on other applicable guidance (for example, inventory) or if specified criteria are met. Breakage revenue will be recognized in proportion to the pattern of rights exercised by the customer if expected breakage is reasonably assured. If not reasonably assured, revenue will be deferred until it becomes remote the customer will exercise its rights under the contract. Evaluation is similar to existing guidance.

Capitalization of contract costs

Breakage (forfeitures)

Gross versus net presentation

Significant increase in disclosure requirements such as: Disaggregation of revenue into primary categories that depict the nature, amount, timing, and uncertainly of revenue and cash flows Tabular reconciliation of the movements in capitalized costs to obtain or fulfill a contract Disclosure Analysis of remaining performance obligations, including nature of goods and services, timing of satisfaction, and significant payment terms Information on onerous performance obligations and tabular reconciliation of movements in the corresponding liability Significant judgments and changes in judgments that affect the determination of amount and timing of revenue Many of the disclosure requirements will apply to interim periods, if material. Certain exceptions will be available for nonpublic entities. Transition Retrospective application to all periods, with certain relief accommodations.

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Setting the standard 26

Appendix, continued
Leases: summary of joint board decisions to date
Component Current proposal Includes contracts in which the right to use a specified asset (explicitly or implicitly identified) is conveyed, for a period of time, in exchange for consideration. Excludes: (1) leases to explore for, or use, minerals, oil, natural gas, and similar non-regenerative resources, and (2) leases of biological assets. Includes the fixed non-cancellable term plus any options to extend or terminate when a significant economic incentive exists (for example, bargain renewal options). Requires reassessment when there is a significant change in one of the indicators (excluding changes in market rates after lease commencement) relating to significant economic incentive. The following variable lease elements will be included in lease payments: Future lease payments based on a rate or index Disguised minimum lease payments Variable lease payments For lessees, residual value guarantees expected to be paid Lease payments based on a rate or index will initially be measured at the spot rate at lease commencement; reassessment will be required as rates or indices change. Contingent rents based on usage or performances will not be included, unless they are disguised minimum lease payments. Lessees will discount lease payments using the rate being charged by the lessor if known; otherwise, the lessees incremental borrowing rate is used. Lessors will discount lease payments using the rate they charge in the lease. Discount rate The discount rate will be reassessed only when there is a change in the lease payment due to: A change in the assessment of whether the lessee has a significant economic incentive to exercise an option to extend the lease or purchase the underlying asset. The exercise of an option that the lessee did not have a significant economic incentive to exercise. At commencement, all lessees will recognize a liability at the present value of the lease payments, and a right-of-use asset equal to the lease liability plus initial direct costs. The pattern of profit and loss recognition will depend on whether the interest and amortization (I&A) approach or the single lease expense (SLE) approach is applied. In determining which approach to use, the lessee evaluates whether they acquire or consume more than an insignificant portion of the underlying asset over the lease term. Lessors will apply either a financing approach (receivable and residual model) or an approach similar to operating lease accounting using the same consumption principle as lessees. Under the receivable and residual model, the lessor will derecognize the leased asset and record a lease receivable and a

Scope

Lease term

Lessee accounting

Lessor accounting

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Setting the standard 27

Component

Current proposal residual asset. Day-one profit will be recognized related to the lease receivable, but profit related to the residual asset will be deferred and only recognized after the initial lease ends. Similar to operating lease accounting, the leased asset will remain on the lessors balance sheet and income will be recognized on a straight-line basis over the lease term.

Short term leases

Lessees and lessors can elect to account for leases that have a maximum term of 12 months or less (including any renewal options) in a manner similar to todays accounting for operating leases. Lessees will follow existing guidance on impairment of fixed assets when evaluating the right-of-use asset. Under the IASB's proposal, lessors can apply the three-bucket model or a simplified approach in which lease receivables will have an impairment allowance measurement objective of lifetime expected credit losses at initial recognition and through the lease receivables life. Under the FASB's proposal, lessors will follow the current expected credit loss approach. Lessors follow existing guidance for fixed assets when evaluating the residual asset.

Impairment

Separating lease and non-lease components

Lease and non-lease components (e.g., service elements and executor costs such as real estate taxes, insurance, and utilities) in a multiple element contract will be identified and accounted for separately. Lessees will deduct incentives that meet the definition of initial direct costs from the right-of-use asset. Other upfront payments will be netted against total lease payments when calculating the lease liability. The accounting for amounts paid by lessors to lessees will depend on whether the payment meets the definition of an initial direct cost.

Lease incentives

Sale leaseback

When a sale has occurred, the transaction is accounted for as a sale and then a leaseback. Entities will apply the control criteria in the revenue recognition project, supplemented by additional clarification in the leases project, to determine if a sale occurred. A change in circumstances other than a modification to the terms that affect the assessment of whether a contract is, or contains, a lease will result in reassessment. When there is a contract modification that results in a different determination as to whether the contract is, or contains, a lease, the original contract will be considered terminated and the modified contract accounted for as a new contract. Subleases will be accounted for as two separate transactions. That is, a sublessor will apply lessee accounting on the head lease and lessor accounting on the sublease. Lessees will disclose a reconciliation of the opening and closing balance of lease liabilities for both I&A and SLE leases, a single maturity analysis of the undiscounted cash flows for all lease liabilities, and costs relating to variable lease payments not included in the liability. Lessors will disclose a table of all lease-related income items, a reconciliation of the opening and closing balance of the right to receive lease payments and residual assets, and a maturity

Contract modifications or change in circumstances after the date of inception of the lease Subleases

Disclosure

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Setting the standard 28

Component

Current proposal analysis of the undiscounted cash flows that are included in the right to receive lease payments. Note: This summary is not inclusive of all required disclosures. Transition requirements will be applied to all leases existing at the beginning of the earliest comparative period presented. Lessees For leases previously classified as capital/finance leases, a lessee will not be required to make adjustments to the carrying amount of lease assets and lease liabilities and will reclassify them as right of use assets and liabilities to make lease payments. For leases previously classified as operating leases, a lessee will recognize liabilities to make lease payments and right of use assets at transition. Lessees applying the I&A approach can elect a modified retrospective or full retrospective approach. Lessees applying the SLE approach can elect a simplified retrospective or full retrospective approach. Lessors For capital/sales type and direct finance leases a lessor will not be required to make adjustments to the carrying amount of the assets associated with those leases. For operating leases a lessor will recognize the right to receive lease payments and a residual asset, and derecognize the underlying asset. Lessors can apply the full retrospective or modified retrospective approach.

Transition

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Setting the standard 29

Appendix, continued
Insurance contracts: summary of joint board decisions to date
Component Current proposal Applies to all entities that issue insurance contracts (as defined), not just insurance entities. Scope Excludes certain contracts that otherwise meet the definition of insurance contracts (e.g., certain warranties and certain fixed fee service contracts). The model is current value (i.e., based on the present value of expected future cash inflows and outflows, updated each period). The IASB model includes an explicit risk adjustment while the FASB model does not. Acquisition costs Cash flows will be reduced by the direct costs associated with selling, underwriting, and initiating contracts, although the FASB will only include costs for successful efforts. This approach is permitted by the IASB when it is a proxy for the current value measurement model. It is required by the FASB when specified criteria are met. It is used for measuring the pre-claim liability for certain short duration contracts; current value measurement model will still apply to incurred claims. The same measurement model used for other contracts will be applied to reinsurance. Reinsurance Gains on ceded reinsurance will be deferred, and losses relating to reinsurance of past events will be recognized immediately. Certain components not closely related to the coverage provided by the contract will be unbundled (e.g., embedded derivatives and certain services) and accounted for under other guidance. Most deposit components will not be unbundled and accounted for under a different model, but will be excluded from premiums and claims in the income statement. Recognize at the start of coverage period unless onerous; derecognize when extinguished. Potentially requires certain line items to be included in the statement of comprehensive income, including premiums, claims, benefits, and underwriting margin. Presentation and disclosure Requires qualitative and quantitative information about amounts recognized in the financial statements and the nature and extent of risks, as well as balance rollforwards. Changes in the liability relating to discount rates will be recorded in other comprehensive income, rather than earnings. Transition Apply full retrospective method, with practical expedients to estimate margin and discount rates.

Measurement model

Simplified measurement model (premium allocation approach)

Unbundling

Recognition and derecognition

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Setting the standard 30

Edited by:
Jan Hauser Partner Phone: 1-973-236-7216 Email: jan.hauser@us.pwc.com Kevin Catalano Partner Phone: 1-973-236-5057 Email: kevin.catalano@us.pwc.com Gregory Johnson Director Phone: 1-973-236-7365 Email: gregory.johnson@us.pwc.com Andrew Barclay Senior Manager Phone: 1-973-236-4741 Email: andrew.x.barclay@us.pwc.com

Setting the standard is prepared by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

US GAAP Convergence & IFRS Effective dates and transition methods

In brief An overview of financial reporting developments


IFRS Foundation responds to SECs final report on IFRS Work Plan
What's new?
On October 23, 2012, the IFRS Foundation (the organization that oversees the IASB) published a response (the Foundation Staff response) to the SECs final report on its 1 IFRS Work Plan (the SEC Staff report) issued in July 2012. The IFRS Work Plan was intended to aid the SEC in evaluating the implications of incorporating IFRS into the US financial reporting system. The IFRS Foundation Trustees had committed to carefully considering the SEC Staffs observations. The Foundation Staff response is an assessment of the matters discussed in the SEC Staff report, including the operations of the IFRS Foundation and the IASB, the use of IFRS as global accounting standards, and issues related to incorporating IFRS into the US financial reporting system. Michel Prada, Chairman of the IFRS Foundation Trustees, summarized the major finding of the Foundation Staff response in comments accompanying its release: While acknowledging the challenges, the analysis conducted by the IFRS Foundation Staff shows that there are no insurmountable obstacles for adoption of IFRSs by the United States, and that the US is well placed to achieve a successful transition to IFRSs, thus completing the objective repeatedly confirmed by the G20 leaders. Refer to the SEC Staff report and the Foundation Staff response for more details.

No. 2012-47 October 29, 2012

What is in the response?


The SEC Staff report identifies potential improvements in areas such as the funding of the IASB, the comprehensiveness of IFRS and the IFRS interpretative process, the enforcement and coordination activities of regulators across territories, and the IASBs coordination with national standard setters. The Foundation Staff response addresses each of these areas and discusses responsive actions that, in many cases, are in progress. In some areas, the Foundation Staff response outlines different conclusions than those reached in the SEC Staff report. The Foundation Staff response also provides certain information that the Foundation Staff believes complements the SEC Staffs analysis.

Refer to Dataline 2012-06, SEC Staff releases its final report on its IFRS Work Plan.
In brief 1

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In response to the challenges outlined in the SEC Staff report of a transition to IFRS, the Foundation Staff response discusses lessons learned from the transitions of other territories. Specifically, it notes that issues of sovereignty, endorsement, investor education, human-capital readiness, and transition costs have been successfully addressed by other territories. Other notable observations made by the Foundation Staff in this area include:

If an endorsement process is used to incorporate IFRS, a high threshold is needed for non-endorsement. A gradual incorporation approach through convergence might be an appropriate short-term strategy for transitioning to IFRS, but it cannot be a substitute for IFRS adoption. The viability of a gradual introduction of IFRS on a standard-by-standard basis is questionable. Optional use of IFRS for certain companies could provide the SEC with important data on the practical application of IFRS by US companies, but should only be used as a short-term strategy.

The Foundation Staff response also discusses the benefits of IFRS, including how the US might benefit from adoption, and notes that this was not a focus of the SEC Staff report. An academic analysis on the topic is included as an appendix.

What conclusions are reached?


The Foundation Staff response does not reach any formal conclusions and is not a due process document of the IFRS Foundation. The Foundation Staff response recognizes that the size of the US economy presents significant transitional challenges that are unique to the United States. However, it states that the experience of other territories suggests many of the challenges can be overcome with the appropriate political will to make a commitment to the mission of a single set of global standards. The Foundation Staff also believes that in many areas the United States is better prepared than other territories to consider the adoption of IFRS.

Who's affected?
The Foundation Staff response has no immediate direct impact. However, it provides additional information and perspectives for the SEC to consider in its evaluation of whether, when, and how IFRS might be incorporated into the US financial reporting system.

What's next?
There are no next steps publicly announced by either the IFRS Foundation or the SEC. The SEC Staff report indicates that additional analysis is necessary before any decision is made about incorporating IFRS. The timing of this additional activity is currently unknown, but we expect it to extend beyond 2012.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact David Schmid (1-973236-7247) or Erin Bennett (1-973-236-4623) in the National Professional Services Group.

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In brief

Authored by:
David Schmid Partner Phone: 1-973-236-7247 Email: david.schmid@us.pwc.com Erin Bennett Senior Manager Phone: 1-973-236-4623 Email: erin.bennett@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Dataline A look at current financial reporting issues


SEC Staff releases its final report on its IFRS Work Plan
Overview
Whats inside: Overview .......................... 1
At a glance ...............................1 The main details ..................... 2

No. 2012-06 August 8, 2012


(Revised September 17, 2012*)

At a glance On July 13, 2012, the SEC Staff published its final Staff Report (the "Staff Report") on the potential impact of incorporating IFRS into the US financial reporting system. The Staff Report summarized the Staff's findings in six key areas introduced in its February 2010 Work Plan, intended to aid the SEC in considering whether, when, and how to incorporate IFRS. The Staff Report did not include a recommendation on whether (or how) IFRS should be incorporated into the US financial reporting system. It also did not indicate when such a decision might be made, provide a timeline of next steps, or address whether US public companies should have the option to adopt IFRS on a voluntary basis. The Staff Report noted that a vast majority of participants in the US capital markets do not support outright adoption of IFRS by US issuers. Other forms of incorporation, such as an endorsement mechanism, are viewed more favorably. It also noted that:

The six key areas studied ...........................3


Sufficient development and application of IFRS for the US domestic reporting system .................. 3 The independence of standard-setting for the benefit of investors ......... 6 Investor understanding and education regarding IFRS ..................................... .8 Regulatory environment ..... .10 Impact on issuers................... 11 Human capital readiness ......14

Next steps ....................... 16 Questions ....................... 16

IFRS is generally perceived to be of high quality, but its interpretations should be timely, education is needed to improve investor understanding, and increased cooperation among regulators would improve application and enforcement. A mechanism to consider the needs of the US capital markets, such as the FASB endorsing IFRS, may be needed. The IASB should also consider expanding reliance on national standard setters for assistance with projects, outreach with local investors, and assistance with post-implementation reviews. The IFRS Foundation strikes a reasonable balance between overseeing the IASB and respecting its independence, but the IASB will need independent sources of sustainable funding.

* This Dataline has been revised to clarify and enhance its text. The substance of the Dataline is unchanged.

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Dataline

The main details .1 The SEC Staff embarked on a Work Plan in February 2010 to consider specific factors relevant to an SEC decision of whether, when, and how IFRS may be incorporated into the US financial reporting system. The Work Plan called for a study of six key areas: (1) sufficient development and application of IFRS for the US domestic reporting system; (2) the independence of standard setting for the benefit of investors; (3) investor understanding and education regarding IFRS; (4) the effect on the regulatory environment; (5) the impact on issuers; and (6) human capital readiness. .2 In executing the Work Plan, the Staff provided two status updates and issued three separate papers. The first paper, issued in May 2011, explored a possible incorporation method (the "endorsement approach") whereby the FASB would remain the US standard setter. It would endorse new IFRS into the US financial reporting system if it found the guidance acceptable, and would consider how to conform US standards to existing IFRS. In November 2011, the Staff issued two papers, A Comparison of US GAAP and IFRS and 1 An Analysis of IFRS in Practice. .3 The Staff Report did not include a decision on whether, when, and how IFRS may be incorporated into the US financial reporting system. There was significant support from those contacted during the Staff's outreach for some method of incorporation, and for a set of high-quality, globally accepted financial reporting standards. PwC observation: The Staff Report was not intended to answer the threshold question of whether a transition to IFRS is in the best interests of US capital markets and US investors. Instead, its purpose was to consider information relevant to this threshold question. The Staff Report gives no indication of the timing or process for such a determination. We believe several factors may have contributed to the SEC's decision to continue studying the threshold question, including the current status of the IASB and FASB convergence projects, a focus by the SEC on other required rulemaking (e.g., Dodd-Frank), and the uncertainty resulting from the upcoming November presidential and Congressional elections, which could delay a decision on IFRS beyond 2012. .4 The Staff found a lack of support for an outright-adoption approach. US capital market participants were concerned that outright adoption would decrease the US influence on IFRS standard setting. They also believe that the burden of converting to IFRS was too high and that the extensive use of US GAAP terminology in regulations and contracts would make outright adoption challenging. .5 While it is not a surprise that the Staff Report did not include a decision about whether to transition to IFRS, there have been expressions of disappointment from the international standard-setting community. The chairman of the IFRS Foundation made the following comment in response to the release of the Staff Report: "While recognizing the right of the SEC to determine the method and timing for incorporation of IFRSs in the United States, we regret that the Staff paper was not accompanied by a recommended action plan for the SEC."

Refer to Dataline 2011-36, SEC Staff continue progress on IFRS work plan, for further information about these Staff papers.
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The six key areas studied


1. Sufficient development and application of IFRS for the US domestic reporting system .6 The Staff evaluated the comprehensiveness, comparability, auditability, and enforceability of IFRS. Comprehensiveness of IFRS .7 The Staff compared US GAAP as of June 30, 2010 to IFRS, as promulgated by the IASB, as of January 1, 2010. The review omitted an in-depth analysis of the standards that are the subject of ongoing joint standard-setting projects between the FASB and IASB, as well as the requirements of SEC interpretations and those of standard-setting and regulatory authorities in other jurisdictions. .8 The differences were categorized into four areas where the impact on the reported information could be significant: Those existing in standards subject to the Boards' joint projects Standards that have similar objectives, or are substantially converged (or both) Standards with fundamental differences Industry guidance .9 Joint Projects: The Staff Report acknowledged that the boards have made progress on a number of convergence projects, such as revenue recognition, leasing, and financial instruments. However, the extent of differences that remain between IFRS and US GAAP is greater than the Staff expected at the time it commenced the Work Plan in 2010. The Staff indicated that the continued ability of the boards to operate together effectively is often cited as an area of concern. PwC observation: The boards continue to make progress on many areas of joint focus. The consolidations and fair value standards have been issued. The proposed revenue standard has been re-exposed, with a final standard targeted for 2013. The proposed leasing standard will be re-exposed in the fourth quarter of 2012, with a final standard expected in late 2013 or early 2014. On the other hand, the boards continue to struggle to find common ground on all of the important aspects of the financial instruments project. Although they have moved closer in some areas (e.g., the threecategory, financial-asset measurement approach), they are not converged in others (e.g., impairment). The timelines for completion of some areas that originally had a joint focus, such as insurance contracts, remain uncertain. While, at times, the convergence process has been difficult and time-consuming, it has improved both IFRS and US GAAP. On balance, the process of bringing the two sets of standards closer together has been worthwhile. .10 Similar or Converged Standards: For standards that are similar or substantially converged, such as for business combinations, basic debt instruments, share-based compensation, and earnings per share, the Staff expects that the reported amounts and disclosures under IFRS would be similar under US GAAP. However, the differences that still exist, such as in scoping, detailed requirements, and illustrative and application guidance, could result in different amounts or disclosures.

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Dataline

.11 Fundamental Differences: The Staff observed that fundamental differences between IFRS and US GAAP arise when: a) standard-setters are addressing different circumstances, objectives, or perspectives (e.g., how best to report the economics of a transaction); b) there are differing market or regulatory structures; or c) US standard setters establish anti-abuse provisions. The Staff suggested that resolving these differences may prove difficult. .12 Some examples of these differences identified in the Staff Report include: Impairments of property, plant, and equipment, intangible assets, and inventory US GAAP prohibits reversal of impairment losses; IFRS permits reversal in some circumstances. Inventory costing methods US GAAP permits use of the last-in, first-out ("LIFO") method; IFRS does not. Accounting for research and development costs US GAAP requires all research and development costs to be expensed; IFRS requires capitalization of certain development costs. .13 The Staff Report notes that a change from using LIFO inventory valuation under US GAAP may have a significant impact on net income and cash taxes for US issuers. US tax rules have conformity provisions that only permit the use of a method under tax rules if it is used for book-accounting purposes. Accordingly, absent a change in tax legislation, use of a LIFO inventory valuation approach would no longer be permitted for tax-reporting purposes if an issuer applied IFRS. .14 Industry Guidance: US GAAP contains industry-specific guidance, which does not exist in IFRS. The guidance, such as for rate-regulated and oil and gas entities, was specifically tailored to meet the financial reporting needs of entities in certain industries. It also responded to situations where application of more general guidance was unclear or deemed to result in less relevant information. The Staff believes that industry guidance should not be removed from US GAAP until the IASB has had time to perform outreach to investors, assess the effects of removing that guidance, and develop its own guidance, as appropriate, to fill any void in IFRS. Comparability within and across jurisdictions .15 The Staff analyzed the extent to which financial statements prepared under IFRS are comparable within and across jurisdictions. The Staff reviewed a sample of 183 fiscal 2009 annual consolidated financial statements of SEC registrants (foreign private issuers) and non-registrants that were prepared using IFRS. While the financial statements generally appeared to comply with IFRS, two themes emerged: The transparency and clarity of financial statements could be enhanced across all topical areas. For example, the Staff observed instances where preparers omitted accounting policy disclosures, provided insufficient detail in their accounting policy disclosures to support an understanding of the financial statements, and used terms that are inconsistent with terms used in IFRS. The Staff noted that some disclosures referred to local accounting and reporting guidance, the specific requirements of which were unclear. Thus, the disclosures were insufficient to determine whether the preparers had complied with IFRS. Diversity in the application of IFRS presents a challenge to comparability across industries and territories. The Staff observed that this diversity may be the result of options available to preparers under IFRS, a lack of application guidance, and possibly noncompliance. The local diversity in the application of IFRS was sometimes mitigated by local guidance that narrowed the range of acceptable
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alternatives under IFRS. A tendency of preparers to use local country GAAP in the absence of IFRS guidance was also a mitigating factor. However, the application of local country GAAP diminishes comparability globally. .16 It is noteworthy that the Staff's November 2011 paper, An Analysis of IFRS in Practice, did not compare the application of IFRS to the application of US GAAP. Similar observations as those above may result from a comparison between financial statements prepared under US GAAP and IFRS. The Staff also indicated that improvements to the IFRS Interpretations Committee's ("IFRS IC") processes for issuing application guidance could enhance financial statement comparability. PwC observation: We believe that an expectation gap exists in the US regarding the amount of IFRS interpretation and application guidance that users expect versus the relatively low volume of guidance that has been provided. This is in contrast to the amount of guidance provided by the FASB. As major new standards are expected to be released beginning in 2013, we expect to see the demand for interpretations increasing further.

Auditability and enforceability .17 Principles versus Rules: IFRS is generally thought to allow for greater flexibility in accounting because it is perceived to be more principles-based and thus less prescriptive than US GAAP. The Staff, however, noted that both US GAAP and IFRS reflect a combination of rules-based and principles-based standards. The Staff referred to FASB Statement No. 167, Consolidation of Variable Interest Entities, as an example of a less prescriptive US GAAP standard, when compared with its predecessor, that requires the application of significant judgment. The Staff observed preparers, auditors, and regulators appear to have been able to apply and enforce its guidance. .18 Audit Firm Structure: The Staff Report recognized that the major accounting firm networks have established infrastructures that can provide IFRS support to preparers. However, the Staff noted that a more top-down IFRS interpretation function at these networks, rather than the current decentralized, voluntary, consensus-building processes of individual member firms in the network, would help to foster comparability in the application of IFRS. The major US accounting firms advised the Staff that they believe the IFRS infrastructures in place are suitable to support an environment in which IFRS is incorporated into the US financial reporting framework. .19 The Staff also performed outreach to a number of smaller accounting firms. It found that many of them had limited exposure to IFRS and limited resources trained to apply IFRS. .20 Enforcement and Compliance: Staff research indicated a less active financial statement review program in the European Union versus in the US. The Staff believes that an active review program can have a greater impact in promoting consistent application than the standard itself. .21 The Staff also reviewed a number of prior enforcement actions involving accounting violations and financial fraud to assess its ability to have brought those actions if IFRS had been used. The Staff believes that a significant majority of the accounting actions still would have been brought. .22 Additionally, the Staff Report noted the efforts of three regulatory bodies to improve the consistency of enforcement of IFRS the International Organization of Securities

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Dataline

Commissions, the European Securities and Markets authority, and the Asia-Oceanian Standard-Setters Group. PwC observation: The adoption of international standards in all major capital markets will not, by itself, achieve the vision of a single set of consistently applied, high-quality, accounting standards. We believe that, in addition to completion of the convergence projects, greater cooperation is needed from national regulators to promote consistency. In its recent strategy review, the Trustees of the IFRS Foundation acknowledged that the IASB needs to establish formalized cooperation agreements among securities regulators, audit regulators, and national standard setters to receive feedback on how IFRS is being implemented.

2. The independence of standard-setting for the benefit of investors .23 The Staff evaluated the governance structure, composition, and funding of the IFRS Foundation, a non-profit entity charged with oversight of the IASB. It also considered the independence of the IASB from the IFRS Foundation in the standard-setting process. Oversight of the IFRS Foundation, including structure and effectiveness reviews .24 The Staff Report summarized the IASB's three-tier governance structure, whereby the IASB is overseen by the IFRS Foundation. The IFRS Foundation, in turn, is subject to public oversight by the Monitoring Board, which consists of capital market authorities responsible for the form and content of financial reporting in capital markets in their jurisdictions. .25 The Staff Report acknowledged that the recent strategic review conducted by the Trustees of the IFRS Foundation, and the recent governance review conducted by the Monitoring Board, found this structure to be appropriate. The overall design of the governance structure of the IFRS Foundation strikes a reasonable balance of providing oversight of the IASB while recognizing and supporting its independence. However, it may be necessary to put in place mechanisms to consider and protect the US capital markets, for example, by maintaining an active role for the FASB in standard setting. .26 The Staff Report noted the Trustees' recommendation that the roles and responsibilities of each element of the IASB's governance be more clearly defined. The Staff Report also discussed the composition of the Monitoring Board and its role in nominating and appointing Trustees of the IFRS Foundation. PwC observation: The Monitoring Board, which includes the SEC, provides a link between capital market regulators and the IFRS Foundation. Improvements to the Monitoring Board are in process as a result of its recent governance review. They include expanding the size of the Monitoring Board, refining its membership criteria, and increasing the transparency of its activities. The criteria refinements limit membership to countries that allow local use of IFRS ("domestic use" criterion). It is unclear whether this would affect the continued participation of the SEC on the Monitoring Board. For example, is the SEC's prior decision to permit foreign private issuers to file financial statements in accordance with IFRS sufficient to meet this criterion?

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Dataline

Composition of the IFRS Foundation and the IASB .27 The Staff Report summarized the structure, composition, and selection process for IFRS Foundation Trustees and IASB members, and the involvement of the Trustees in the standard-setting process. The Staff noted that up to three members of the IASB may be part-time members and retain their association with an employer. While this does not appear to have resulted in an issue, it creates a possibility that those individuals will not be viewed as objective. .28 The Staff Report summarized the IASB's post-implementation review process, which consists of a review by the IASB of new IFRS and major amendments to existing IFRS. The Staff Report noted that the IFRS Trustees should consider altering the reporting structure for post-implementation reviews by having IASB staff who conduct the reviews report to the IFRS Foundation Trustees rather than to the IASB. This would be similar to the way the FASB staff who review US standards report directly to the Financial Accounting Foundation ("FAF") Board of Trustees and President/CEO. The Staff believes the public is likely to regard the reviews as more credible if the IASB is not reviewing its own work. Funding of the IFRS Foundation .29 The Staff Report evaluated the IFRS Foundation's desired funding principles, as well as its current sources of funding. The focus was on whether the funding sources and methods are consistent with maintaining the IASB's independence, and whether present sources of funding are sustainable. .30 The Staff identified the following primary concerns: Approximately 25 percent of 2012 funding is expected to come from large accounting firms. Continued reliance on this funding source causes concern about the adequacy and independence of the funding model. While the United States is one of the largest contributors to the IASB, recently the IFRS Foundation Trustees have not been successful in meeting their funding objectives for the United States. A source of continued funding of the US portion of the Foundation's operating budget has yet to be identified. The criteria for membership on the IFRS Foundation Monitoring Board include a requirement for financial contributions by the member's jurisdiction. Neither the SEC nor its Staff can act as a fundraiser and there is a question whether the SEC could contribute its own funds. Thus, the SEC's membership on the Monitoring Board depends on others in the United States funding the Foundation. It appears that less than 25% of countries that have incorporated IFRS in some form contribute to the IFRS Foundation. IASB standard-setting process .31 The Process: The Staff Report reviewed the IASB's standard-setting process and noted that the Staff attends meetings of the IFRS Advisory Council, the IFRS IC, and, occasionally, meetings of project-specific advisory groups, as an observer. The Staff also noted that it reviews IASB standard-setting documents in much the same way it conducts its reviews of FASB standard-setting documents. .32 Focus on Investors: The Staff Report considered the IFRS Foundation and IASB objective to provide standards that communicate a faithful presentation of an entity's financial position and performance. The Staff elaborated on the IASB's efforts to involve investors in the standard-setting process, and concluded that the IASB has made good

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Dataline

faith efforts to understand and meet investor requests for improvements to financial statements. .33 Timeliness: The Staff acknowledged that the Trustees of the IFRS Foundation have recommended changes to the IFRS IC that have not yet been implemented. Based on its monitoring and outreach activities, the Staff believes enhancements are needed to address emerging issues on a timely basis. .34 Objectivity: The Staff observed that the IASB's standard-setting process is heavily based on consultations, gathering facts, assessing views, and explaining its decisions to the public. The Staff noted that issues are resolved based on their technical merits and a focus on usefulness to investors and is not aware of instances where IASB members failed to exercise independent judgment in setting IFRS. .35 Continuing Role for the FASB: The Staff noted that establishing the FASB as an endorser of IFRS for the US financial reporting system could help to address some of its concerns related to the timeliness of standard setting and the need to maintain focus on the needs of US investors. This might include the FASB assisting the IASB with individual projects for which it has expertise, performing investor outreach, identifying areas in which there is a need to narrow diversity in practice or issue interpretive guidance, and assisting with post-implementation reviews of standards. 3. Investor understanding and education regarding IFRS .36 The Staff considered the impact on investors of incorporating IFRS into the US financial reporting system. This involved assessing how investor understanding of IFRS could be promoted, as well as the robustness of existing mechanisms for educating investors about changes in accounting standards. .37 Investors generally expressed support for a transition to a single set of high-quality, globally accepted accounting standards. But this support is conditional on the quality of IFRS and the approach and timeliness of the IFRS IC in interpreting IFRS. .38 Some investors noted concerns over the quality of IFRS, the perceived lack of independence of the IASB, including regarding its funding and the potential for political interference in its processes, and the lack of investor participation on the IASB and the IFRS Foundation. Investors also stated that the IFRS IC should be more active in interpreting IFRS standards to narrow diversity in practice. PwC observation: The Staff Report indicated that the endorsement approach of incorporating IFRS into the US financial reporting system, together with an active role by the FASB in the standard-setting process, could mitigate many of these concerns.

Current awareness and knowledge .39 The Staff Report noted that US investors' current awareness and knowledge of IFRS varies. Institutional investors are generally aware of the ongoing consideration of IFRS in the US. Many of these investors already use financial information prepared in accordance with IFRS from foreign private issuers registered with the SEC. .40 Some investors are primarily or exclusively focused on domestic companies that report under US GAAP. The Staff observed that these investors are reluctant to commit extensive resources to develop a better understanding of IFRS until the joint projects are completed, and it becomes clear whether and, if so, how the US might incorporate IFRS into the US financial reporting system.
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Dataline

Investor education regarding accounting standards .41 The Staff learned that many investors obtain information about new accounting standards primarily through a company's disclosures about pending or new standards and the effect of such standards on its financial statements. .42 Secondary sources of investor education about new accounting standards are continuing education programs, publications, and speeches. In some cases, investors obtain their education by following the standard-setting projects directly. Any SEC decision to incorporate IFRS into the US financial reporting system would have to consider the amount of time needed by investors to assimilate new standards. Investor preparedness for incorporation of IFRS .43 The Staff Report noted that many US investors have not yet committed extensive resources to develop IFRS knowledge. Therefore, they may not be prepared for a nearterm transition to IFRS. .44 Many investors, however, indicated that preparedness issues would not be a significant impediment to incorporating IFRS. Since US GAAP is not static, the investors are accustomed to changes in accounting standards. .45 The Staff Report indicated that certain individual investors that focus primarily on domestic companies may not have the same resources as large institutional investors, and may not be as prepared for a change. The initial investment in time by this group to obtain IFRS knowledge would likely be disproportionate to that of the large institutional investors. Accordingly, the individual and smaller investor groups preferred a gradual transition approach to incorporation. .46 Investors believe sufficient time should be provided for any transition and that disclosures during transition will be critical to understand the impact of the change. Investor views on the length of time needed for a transition ranged from a few quarters to several years. The Staff noted that the time period for transition could be significantly reduced if, before any incorporation of IFRS occurs, the joint projects are completed and remaining significant differences between US GAAP and IFRS are narrowed. .47 Investors generally favored a retrospective transition to IFRS, as this would provide more comparable financial information in the periods presented during the transition period. Additionally, some investors believe that companies should not be allowed the option of voluntary early adoption because it would affect comparability between US companies. They also believe this would undermine the objective of convergence and potentially cause companies to selectively choose accounting methods that produce the most favorable outcome. .48 Investors communicated that further action by the boards to harmonize US GAAP and IFRS by eliminating differences would improve investor preparedness. If the boards' joint projects do not result in converged standards, investors are concerned that double the effort and cost would be required to first understand the new US GAAP, and later on, the IFRS standard. Other investor views .49 Most investors commenting to the Staff believe that the FASB should have a significant and active role in the standard-setting process, acting in the interests of US constituents and ensuring a US voice in standard setting. In this role, the FASB could endorse the standards that the IASB promulgates, while retaining its authority to issue new standards and interpretations when necessary to protect US investors. Thus, investors believe the FASB could ensure that standards incorporated into the US financial reporting system are of sufficient quality.
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4. Regulatory environment .50 The Staff considered the impact that incorporation of IFRS into the US reporting system would have on the US regulatory environment. .51 In addition to the SEC, various federal, state, and local regulators, such as tax authorities and industry regulators, utilize US GAAP financial information. US GAAP terminology is thus entrenched in laws and regulations, and in a significant number of private contracts. The effort that would be required to change the references from US GAAP to IFRS would be significant. Manner in which the SEC fulfills its role .52 The Staff believes that it is important for the US to continue to have an active role in the development of global accounting standards, and be proactive in identifying and addressing new and emerging financial reporting issues. This was seen as important to help the SEC protect investors, maintain orderly and efficient capital markets, and facilitate capital formation. The Staff believes that the FASB is best equipped and already positioned to fulfill this role. .53 If IFRS is incorporated into the US financial reporting system, the Staff envisions that the FASB would continue to promulgate US GAAP. In the May 2011 Staff paper, it was envisioned that the FASB would be able to endorse the "vast majority" of new IFRS based on its participation in the IASB's standard-setting process, but would retain the authority to modify or add to the requirements of IFRS incorporated into US GAAP. If incorporation occurs through an endorsement process, such that the FASB would have a direct role in issuing standards, the question is how much discretion the FASB should exercise in the endorsement process. PwC observation: An approach of incorporating international standards based on assessing the quality of new and existing international standards would be a fair starting point in achieving the goal of high-quality, globally accepted accounting standards. It would establish a continuing role for the FASB, and maintain the SEC's oversight of accounting standards used by companies that participate in the US capital markets. .54 The number of references to US GAAP in various federal, state, local, and industry rules and regulations is substantial. If a decision is made to incorporate IFRS directly, rather than through an endorsement approach, a comprehensive effort would have to be undertaken to modify each reference to be compatible with IFRS. Regulators indicated that incorporating the content of IFRS into US GAAP, so that US GAAP is effectively the same as IFRS, may address or mitigate this. .55 The SEC has historically recognized standards set by the FASB, and has from time to time published accounting and financial reporting guidance to narrow practice and provide practical implementation guidance. If the SEC were to incorporate IFRS into the US financial reporting system, its ability to perform any of the aforementioned actions, in addition to enforcing against non-compliance, would not change. Industry regulators .56 Various industry regulators, such as those of financial institutions, insurance companies, and public utilities, are responsible for a variety of regulatory functions, including establishing utility rates and approving financial institutions' transactions. These regulators rely heavily on US GAAP financial information. The Staff speculated that this is done in the interests of expedience and because statutes and regulations require the use of US GAAP. Further, some regulators have their own accounting

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Dataline 10

requirements that rely on US GAAP-based inputs. Changing US GAAP would thus significantly impact the regulatory regime. .57 An SEC decision to incorporate IFRS directly would only affect public companies. Regulators, however, have the same reporting requirements for public and private companies. Accordingly, the regulators would have to determine whether they would require regulatory reporting to continue under US GAAP, change to IFRS for all companies, or accept both standards. If a regulator chose to accept IFRS, it would need to assess the differences that use of IFRS may generate, and modify the system of regulatory reporting where necessary. .58 The Staff noted that a decision to incorporate IFRS by endorsement would most likely alleviate a number of these concerns. It would enable regulators to monitor the decisions by the FASB to determine whether a new IFRS standard to be endorsed requires a change to their regulatory systems. Regulators indicated that they have mechanisms in place to address accounting changes, although the sophistication and effectiveness of such procedures varies. Federal and state tax impacts .59 The Staff Report addressed potential effects of incorporation of IFRS on federal tax regulations in the following broad categories: Ability to use the LIFO inventory method for tax purposes Changes in US tax accounting methods where a change in accounting policies is considered a change in accounting method Changes in the computation of US earnings and profits Impact on an organization's existing transfer pricing policies .60 The calculation of state taxes could also be affected by a change to IFRS. Two potential areas cited in the Staff Report are the apportionment of income among jurisdictions, and the extent to which taxes based on an entity's equity or net worth will change when those balances are affected by a change to IFRS. Audit regulation and standard setting .61 The Staff evaluated whether accounting firms have limitations on their ability to perform audits and issue audit opinions on foreign private issuers. Accounting firms indicated that they are able to perform audits and issue opinions on these entities currently, and that a transition to IFRS would not affect their ability to issue audit opinions in the future. .62 In considering how a change to IFRS might affect the PCAOB's auditing standards, the PCAOB staff did not think there was a need to change PCAOB auditing standards to accommodate a particular incorporation method. With limited exceptions, PCAOB standards have been written in a neutral manner to accommodate any accounting standards, and a choice of any particular incorporation method would not have a significant impact. 5. Impact on issuers .63 This section of the Staff Report explored how incorporation of IFRS into the US financial reporting system would impact the 10,000 or so US issuers that file reports with the SEC. The Staff included examination of the following areas:

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Dataline 11

Accounting systems, controls, and procedures Contractual arrangements Corporate governance Accounting for litigation contingencies Smaller issuers versus larger issuers .64 Issuers generally supported the objective of a single set of high-quality, globally accepted accounting standards. The Staff found that support for a single set of global standards varies based on the size of the issuer. Larger issuers tended to be more supportive than smaller issuers. Additionally, the method of IFRS incorporation in the US affected issuers' views. In light of the convergence projects, many issuers expressed concerns about the amount of significant change to the financial reporting system in a relatively short time frame. PwC observation: Many issuers expressed a need for the SEC to provide as much clarity as possible as to the ultimate approach for the further incorporation of IFRS, in order to conduct effective impact assessments and to plan the transition appropriately. This clarity currently does not exist, even after the issuance of the Staff Report.

Accounting systems, controls and procedures .65 When analyzing the impact of IFRS incorporation into the US financial reporting system, the Staff sought to determine the extent of, logistics for, and time necessary to undertake changes to issuer accounting systems, controls, and procedures to facilitate such an incorporation. .66 The Staff Report explained the significant expected investment in changing systems, controls, and procedures. The Staff noted that the significant changes required to adopt new standards resulting from the joint projects would mitigate, to an extent, the incremental efforts of moving to IFRS. .67 The Staff acknowledged that many issuers will not start any plan of IFRS incorporation until the uncertainty of how and when incorporation will happen is resolved. Further, the Staff Report discussed the various methods of transition and their effect on systems, controls, and procedures. Some issuers expressed a preference for a single transition approach (referred to as the "big bang" approach) to incorporation, because they believe it would minimize costs by transitioning at one point in time. However, most expressed a preference for a more gradual transition. Contractual arrangements .68 The Staff observed that the majority of the contracts of US issuers are based on US GAAP. The Staff assessed the types and pervasiveness of contractual arrangements that would be affected by IFRS incorporation, and how these contracts would be affected. The Staff also attempted to determine the cost and estimated time required to address concerns regarding affected contractual arrangements. .69 Two principal types of contract terms would be affected by outright IFRS adoption: (1) terms requiring delivery of US GAAP financial statements and (2) terms requiring that a company achieve or maintain certain financial targets or ratios that are calculated

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Dataline 12

based on US GAAP. The Staff believes that both the scope and volume of affected contracts would be significant. .70 Companies will need to review all of their contracts to identify explicit or implicit references to US GAAP, and to determine how to address provisions that would be affected by incorporation of IFRS. Contracts may need to be renegotiated, which could be complex and time consuming. An appropriate transition period would be necessary to provide issuers enough time to review their contracts and make the appropriate changes. Corporate governance .71 The Staff noted that compliance with corporate governance requirements may be affected by the incorporation of IFRS. For example, existing SEC and stock exchange listing rules require audit committees to include an individual qualified as a financial expert and an individual qualified as financially literate. It is unclear whether such an individual could retain that status after incorporation of IFRS. .72 Some commenters thought that incorporation of IFRS would not call into question the status of audit committee financial experts or individuals qualified as financially literate. Others requested that the SEC or the exchanges (or both) provide a sufficient transition period to address this potential issue. A minority of commenters thought that the Work Plan should address additional issues, such as the accounting knowledge of CEOs and CFOs that is required in order to make the financial statement certifications required under the Sarbanes-Oxley Act. Accounting for litigation contingencies .73 The Staff analyzed the interaction of the accounting and disclosure requirements for litigation contingencies under IFRS with the legal environment in the US, given that IFRS differs from US GAAP in this area. The Staff discussed this with issuers, the legal profession, and investors in order to identify possible approaches to address their concerns. .74 Differences between ASC 450, Contingencies, and IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, include the definition of probable. Under IFRS, probable is defined as more likely than not to occur, which is generally accepted to mean a probability greater than 50 percent (e.g., 51%). Under US GAAP, probable is defined as the future event or events are likely to occur, which generally is interpreted as a percentage much greater than 50 percent. .75 Concerns were expressed about the lower threshold and the different disclosures required by IFRS. The Staff Report noted the controversial nature of recent FASB proposals, which were rejected, to change its loss contingencies disclosure requirements. The IFRS provisions are similar to what the FASB had proposed and thus could be met with similar objections. .76 Other issues include the potential need to revise applicable auditing standards, such as the standard that address inquiry of a client's lawyer. There also may be a need to revise the agreement between the accounting and legal professions regarding lawyers' responses to requests for information from auditors. .77 The Staff observed some inconsistencies in the accounting for litigation contingencies under IFRS. It was unclear whether this was due to preparers relying on an accommodation in IFRS that permits certain disclosures to be omitted if they would seriously prejudice the company's legal position.

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Dataline 13

PwC observation: Recently, the FASB decided to discontinue its loss contingencies project. Constituents' unsupportive feedback, amongst other reasons, led to this decision. This leaves in place a significant difference between the disclosure requirements of US GAAP and IFRS. The FASB indicated that it will consider addressing loss contingencies as part of its disclosure framework project.

Smaller issuers versus larger issuers .78 The Staff Report noted that smaller issuers might bear costs to incorporate IFRS differently than large or global companies. The Staff analyzed how the impact of IFRS incorporation would vary based on an issuer's size and determined possible approaches to mitigate concerns regarding any disproportionate effects of IFRS incorporation on smaller issuers. .79 The Staff performed outreach to smaller issuers through comment requests and a roundtable focused on smaller issuers. The Staff Report acknowledged that all issuers would generally have to perform similar activities to transition to IFRS, and that smaller issuers have more limited resources. The feedback included mixed views about the method of incorporation suitable for smaller issuers. Some supported phased adoptions. Others supported a permanent option to use either US GAAP or IFRS. Finally, some expressed significant concerns that the costs of both transitioning to, and subsequently applying, IFRS would outweigh the benefits of using it. 6. Human capital readiness .80 IFRS incorporation would require sufficient readiness of human capital to execute the change. In this section of the Staff Report, the Staff evaluated education and training, auditor capacity, and how the method of incorporation would affect the level of investment required for preparing human capital. .81 The Staff Report noted that human capital preparedness varies according to the type of company and the method of transition. In addition, the extent to which IFRS and US GAAP are aligned as a result of the joint projects will have a significant impact on the level of preparedness. .82 The Staff Report reviewed two alternatives for acquiring the necessary human capital through the training of existing people or through the recruiting of new employees or hiring of outside consultants who have the appropriate expertise. Both of these alternatives are likely to be costly. .83 While the Staff Report did not reach any conclusion regarding human capital readiness, it noted that by extending incorporation of IFRS over a sufficient period of time, the degree of change should not be significantly different from what individuals experience following the existing pace of FASB standard setting. PwC observation: The FASB and the IASB are actively working together on several priority joint projects. These convergence projects will introduce a significant change to US GAAP, regardless of the decision of the SEC concerning incorporation of IFRS. Addressing these changes requires preparers to employ an organized, methodical approach. Adopting the new standards would improve human capital readiness for IFRS incorporation.

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Dataline 14

Education and training .84 The Staff evaluated the current level of IFRS expertise and the extent of IFRS training needed. The Staff also considered implementation plans for the future training of constituents. Targeted outreach was conducted among issuers, auditors, and regulators to understand the current level of their training efforts, and to consider whether existing processes of identifying and incorporating changes in accounting standards could be employed. .85 The Staff found that IFRS readiness varied greatly among constituents. Those that have an extensive understanding of IFRS are generally associated with the US practices of large accounting firms or large multinational companies with non-US entities that report in accordance with IFRS. Most constituents, including many smaller accounting firms and regulators, indicated having limited internal IFRS training or experience. Generally, those constituents will not invest more resources in IFRS training until there is greater certainty about the timing and method of IFRS incorporation. .86 The Staff's outreach activities confirmed that for the majority of preparers consulted, their current human capital readiness would not be sufficient to accommodate a "big bang" adoption of IFRS. However, other more gradual transition methods would likely reduce the extent to which existing processes would need to be supplemented by outside resources. Generally, those included in the outreach believed that current processes would be sufficient for an endorsement approach. Auditor capacity .87 The Staff analyzed auditor capacity constraints with respect to IFRS by assessing the population of auditors that would be impacted. It evaluated the implication of alternative transition methods by making inquires of accounting firms, issuers and others. .88 The Staff observed that accounting firms' preparedness for IFRS incorporation varies depending on whether IFRS was incorporated into the firm's auditing infrastructure. The largest international accounting firms have already implemented a sufficient quality control infrastructure to accommodate any form of IFRS incorporation. Smaller and mid-size accounting firms have less extensive, if any, IFRS infrastructures in place and may not currently have the capability to support issuers reporting under IFRS or to perform audits of IFRS financial statements. .89 The impact on auditors' capacity and the cost of qualified auditors will likely be influenced by the method and timing of transition. For example, a shorter transition period to adopt IFRS may lead to a shortage of both qualified IFRS auditors and IFRS consultants. A longer, phased-in transition could provide auditors greater opportunity to make the necessary adjustments needed to be ready to provide audit services to IFRS issuers. .90 Some constituents expressed concerns that IFRS incorporation would lead to a further concentration of public company audits among the largest accounting firms, and would restrict competition. A more gradual transition approach under which US GAAP is conformed to IFRS would give auditors the opportunity to keep abreast of changes in US GAAP related to incorporation of IFRS. The Staff observed that a less gradual approach may lead some firms to exit the audit market rather than make the investments needed to audit companies applying IFRS. On the other hand, the Staff noted that IFRS incorporation may introduce new business opportunities for some of the accounting firms.

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Dataline 15

Next steps
.91 The Staff is not requesting comments on the Staff Report, but welcomes any feedback.

Questions
.92 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Global Accounting Services Group in the National Professional Services Group (1-973-236-4377).

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Dataline 16

Authored by:
David Schmid Partner Phone: 1-973-236-7247 Email: david.schmid@us.pwc.com David Humphreys Partner Phone: 1-973-236-4023 Email: david.humphreys@us.pwc.com Dieter Wulff Senior Manager Phone: 1-973-236-4856 Email: dieter.x.wulff@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


SEC Staff releases final report on its IFRS Work Plan
What's new?
On July 13, 2012, the Staff of the SEC's Office of the Chief Accountant published its final report (the "Staff report") on its Work Plan intended to aid the SEC in evaluating the implications of incorporating IFRS into the US financial reporting system. In early 2010, the SEC published a statement of continued support for a single set of high-quality, global accounting standards, and acknowledged that IFRS is best positioned to serve that role. The SEC initiated the Work Plan at that time to obtain information relevant to the determination of whether, when, and how IFRS might be incorporated into the US financial reporting system. Refer to the Staff report for more details.

No. 2012-25 July 16, 2012

What is in the Staff report?


First, what's not in the Staff report is worth noting. The Staff report does not include a final policy decision as to whether IFRS should be incorporated into the US financial reporting system, or how such incorporation should occur. The Work Plan was not intended to provide an answer to the threshold question of whether a transition to IFRS is in the best interests of US capital markets and US investors. Instead, it is an important step in the SEC's decision-making process. In the Staff report, the Staff indicates that IFRS is generally perceived to be of high quality. However, there are areas where gaps remain (for example, accounting for rateregulated industries and insurance) and inconsistencies exist in the application of IFRS globally. These findings were set forth in two separate Staff papers issued last year, A 1 Comparison of US GAAP and IFRS and An Analysis of IFRS in Practice. The Staff also believes that improvements can be made to the IFRS interpretative process, and the enforcement and coordination activities of regulators across territories. Finally, although it acknowledges progress has been made, the Staff believes enhancements should be made to the IASB's coordination with individual country accounting standard setters and the IASB's funding process.

Refer to Dataline 2011-36, SEC Staff continue progress on IFRS work plan, for further information about these Staff papers.
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

The Staff report does not address whether US public companies should have the option to adopt IFRS on a voluntary basis. However, the Staff report does state that investors are generally in agreement that companies should not be permitted to adopt IFRS early, because it would compromise comparability with US companies applying US GAAP.

What conclusions are reached?


As noted above, the Staff report does not reach any conclusions about incorporating IFRS. The Staff report does state, however, that adopting IFRS as authoritative guidance in the United States is not supported by the vast majority of participants in the US capital markets and would not be consistent with the methods of incorporation followed by other major capital markets (for example, the endorsement process followed by the European Commission). On the other hand, the Staff found there to be substantial support for exploring other methods of incorporating IFRS that demonstrate the US commitment to the objective of a single set of high-quality, global accounting standards. Last year, the Staff issued a paper on one possible method, involving an active FASB incorporating IFRS into US 2 GAAP over an extended period of time.

Who's affected?
US public companies will be affected by any decision ultimately made about whether, when, and how IFRS might be incorporated into the US financial reporting system.

What's next?
The Staff report indicates that additional analysis is necessary before any SEC decision is made about incorporating IFRS into the US financial reporting system. The timing of this additional activity is currently unknown, but could extend beyond 2012. The Staff has not requested comments, but welcomes feedback on the Staff report. A PwC webcast has been scheduled for Thursday, July 19, 2012, that will provide insights and observations on the Staff report. Also coming soon is a PwC Dataline that will summarize the Staff report and our observations.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact David Schmid (1-973236-7247) or Dieter Wulff (1-973-236-4856) in the National Professional Services Group.

Refer to In brief 2011-23, SEC Staff Paper explores one possible method to incorporate IFRS in the U.S.
In brief 2

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

Authored by:
David Schmid Partner Phone: 1-973-236-7247 Email: david.schmid@us.pwc.com Dieter Wulff Senior Manager Phone: 1-973-236-4856 Email: dieter.x.wulff@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

view

October 2011

point of

The path forward for international standards in the United States


Considering possible alternatives

Highlights
The SEC has stated it plans to make
a determination on the future use of international standards by US public companies in 2011. rejection of a move to international standards in the US seems increasingly unlikely. A compromise solution will likely be necessary. convergence agenda, enhanced cooperation among key capital market securities regulators and a refocused international interpretations body will provide a more solid foundation for a single set of high-quality global accounting standards.

The international standards' debate continues.


The Securities and Exchange Commission has stated it plans to determine this year whether, when, and possibly how international standards should be incorporated into the US financial reporting system. Those involved in the US financial reporting system seem divided on the best path forward. Our sense is that some of the support is waning for full near-term mandatory adoption of international standards in the US. A May 2011 SEC staff paper describes a slower approach of incorporating international standards into the US financial reporting system, with an objective of US standards being compliant with international standards in perhaps five to seven years. We believe in the vision of a single set of high-quality global accounting standards. Achieving that vision will require more consistent application of international standards across jurisdictions that adopt them. The potential SEC staff approach is a fair starting point and one that can be built upon to make progress towards this ultimate objective.

Full acceptance or complete

Completion of the current

Background

Many possible paths to a common objective

High quality accounting standards The vision is powerful. Few dispute its attainment will have value for investors. A single set of high-quality, transparent, and robust accounting standards, consistently applied by companies in capital markets around the world will enhance the efficient allocation of capital. Worthy companies will find it easier to access low-cost capital to grow. Investor returns will improve. These outcomes are what many envision from a move to a single set of high-quality global standards. For more than ten years, the world's two most significant standard setters, the FASB and IASB - collectively the boards - have brought US and international standards substantially closer together. Throughout the process, the boards have dealt with many thorny, long-standing issues. In some areas of the literature they agreed to remove differences, in other areas they did not. While at times the process has been difficult and time-consuming, it has improved both sets of standards. On balance, most would agree that the process of bringing the two sets of standards closer together has been worthwhile. Approximately 60 countries plus those in the European Union have adopted international standards, in some form, for publicly listed companies. However, adoption of international standards in all major capital markets will not, in and of itself, achieve the vision. This is because the protection of investors and the efficient allocation of capital globally can only be achieved when the common set of highquality global accounting standards is also applied with reasonable consistency. A number of major capital markets have not fully adopted international standards as issued by the IASB. And some believe that the consistency of application of international standards, among those countries that have adopted them, should be improved.

Multiple paths; valid perspectives The alternatives for integrating international standards into the US reporting system are numerous. They range from doing nothing - leaving US accounting unchanged, to abandoning US accounting and adopting international standards all at once, to many possibilities in between. Each has advantages and disadvantages and supporters with strongly-held views. Those advocating leaving US accounting alone assert that it is well established, meets the needs of financial statement users, and has allowed US companies to have the lowest cost of capital. Those advocating changing to international standards cite the benefits of increased global comparability for investors, lower preparation costs (ultimately), and easier cross-border access to capital. Others acknowledge the long-term benefits of international standards, but say that a more gradual implementation process is needed. They believe such an approach could address the lack of a political mandate for change in the US, spread the costs over a longer period, and pragmatically address the multitude of issues that will be encountered. Possible SEC staff approach The SEC staff has been exploring a way to gradually incorporate international standards into the US financial reporting system. Under this scenario, US accounting would continue to exist. The FASB would endorse for use in the US acceptable new international standards resulting from joint or IASB-only projects. The FASB would also evaluate other existing international standards during this time and consider how to conform US standards to them. The ultimate objective would be for US standards to be compliant with international standards in perhaps five to seven years.

Different, but valid and strongly-held, views exist as to whether and how the US should change to international standards.

The SEC staff suggested a possible compromise to start a dialog on potential transition approaches.

PricewaterhouseCoopers LLP 2

Analysis

Compromise, flexibility and a slower transition


No perfect solution We support the thorough way the SEC staff has gathered input, and we are confident thoughtful deliberations will occur among Commission members as they decide the path forward. But based on the political and business landscapes, if an all or nothing decision is to be made, we fear it will be nothing. The US would stay with its own accounting - and in the long run, that would be unfortunate. Though sufficient support for change does not currently exist, in our view, progress toward achieving the vision should not stop. Standard setters and regulators Today, achieving the vision remains a longer-term objective. Though standard setters have worked diligently, and great progress has been made, all major convergence projects are not yet complete. Allowing an option to change to international standards If using international standards were allowed, most US companies would need at least four years to put in place the systems and controls necessary to adopt them. Also, the expected timing for issuance of standards resulting from the major convergence projects will likely be late in 2012. Given this timing, the retrospective adoption provisions, and the effort required of companies to make needed system and control changes, most interested US companies wouldn't adopt the new convergence standards or international standards until 2015. Significant progress can be achieved between now and 2015 in standard setting and regulatory cooperation. For example, completing convergence projects, further improving international standards consistent with the IASB's new agenda, putting a foundation in place to enhance the consistency of application, and resolving numerous US transition issues can be accomplished. We believe that the SEC should monitor progress between now and 2015. If sufficient progress continues, the SEC should target the beginning of 2015 to allow US companies to optionally adopt international standards. In conclusion The potential SEC staff approach of slowly incorporating international standards based on assessing the quality of new and existing international standards is a fair starting point. It establishes a continuing role for the FASB and maintains the SEC's oversight of accounting standards used by companies that participate in the US capital markets. In addition, by addressing the practical consequences of making fundamental changes to US financial reporting, we believe the SEC staff is moving the ball forward. Although the vision is clear, the pathway is not. More consistency, compromise, and a slower transition plan will increase support among US companies to move to international standards. Continued dialog and increased cooperation are needed, but the worthiness of the goal demands that progress continue to be made.
PricewaterhouseCoopers LLP 3

We believe in the vision - a single set of high quality, transparent and robust global accounting standards.

We are convinced that only international standards can be the foundation for this vision.

We believe that the boards should continue working together to finish the current convergence projects. After completing those projects, the boards should continue collaborating to enhance the quality of financial reporting in areas where common needs for improvement exist. We realize that many inside and outside the US tire of convergence. Nevertheless, the benefits for investors of eventually getting to high-quality global accounting standards are worth the price of continued collaboration for a period of time. In addition to improved standards resulting from convergence and collaboration, a key to achieving the vision is establishing an effective foundation to enhance the consistency of application. This would assist investors in attaining maximum benefits from high-quality global standards. The regulatory and standard setting mechanisms to facilitate improved consistency in application are, for the most part, not yet in place or do not yet operate at a sufficiently high level. Enhanced cooperation and coordination is needed among national regulators, the IASB and its interpretive body, auditors, and preparers to facilitate more consistent application of international standards.

The SEC staff's suggested direction is a fair starting point in making progress towards achieving this vision.

Questions and answers

Q: How can increased regulator collaboration facilitate more consistent application of international standards? A: Increased collaboration can be achieved through greater focus on consistent application, improved communication between regulators, and cooperation agreements. One example of a cooperation agreement relates to companies seeking cross-border capital in public markets. Major capital market securities regulators could agree that any company purporting to follow IFRS and seeking public capital in another market, but not following that market's accounting principles, would be required to file periodic financial statements with the securities market regulator in which capital is being raised, using standards issued by the IASB. The financial statements of those companies would be subject to reviews by regulators in the countries where capital is raised. If instances of non conformity with standards issued by the IASB are identified, those matters would be resolved through discussions between the company, their home market securities regulator, and the securities regulator where the filing occurs. In this way, these cooperation agreements would enhance the sharing of information and help to reconcile views. Consistent application of international standards also would be enhanced through regulatory reviews aimed at identifying unacceptable differences in the application of international standards. Agreements among capital market securities regulators to refer interpretation and application differences to a refocused interpretations committee would also assist in achieving a higher degree of reasonable consistency.

Q: Some suggest that companies should be permitted to move to international standards as early as possible. You suggest such an option should be targeted for the beginning of 2015. Why? A: As a practical matter, key convergence standards are not expected to be effective until 2015 at the earliest. Even if early adoption of these new standards were allowed, because of the changes needed to systems and controls to implement them, and the retrospective adoption requirements, we believe many companies would not want to adopt them before 2015. Preparations to use international standards would take at least as long. As a result, we believe the SEC should use the time leading up to 2015 to monitor further development of international standards and the progress toward putting a foundation in place to improve the consistency of application. If sufficient progress is made, the SEC should allow US companies the option to change. Q: The SEC staff paper envisions an endorsement process that allows the FASB to modify international standards as they are incorporated. Will this work against the goal of a single set of global standards? A: The ability to modify standards through endorsement could result in a US "flavor" of international standards. This is why the threshold for making modifications is so important. Careful consideration must be given to the criteria. We believe that the threshold should be set at a level that would result in minimal modifications. The SEC staff's suggestion that the threshold consider "the public interest and the protection of investors" is a good starting point.

Contact Information
To have a deeper discussion about our point of view on international standards in the United States, please contact:

Michael Gallagher Managing Partner, Assurance Quality & Transformation Phone: 646-471-6331 Email: michael.j.gallagher@us.pwc.com James Kaiser U.S. Convergence and IFRS Leader Phone: 267-330-2045 Email: james.kaiser@us.pwc.com

2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.

US GAAP Convergence & IFRS Financial instruments

In brief An overview of financial reporting developments


IASB proposes limited amendments to its financial instruments guidance under IFRS 9
What's new?
This week, the IASB issued its exposure draft proposing limited amendments to IFRS 9 (2010), Financial instruments. The proposed amendments are intended to:

No. 2012-55 November 29, 2012

Address application issues that have arisen since the original issuance of IFRS 9 with regard to financial assets measured at amortized cost Consider the interaction with the IASBs insurance project Reduce differences between IFRS 9 and the FASBs proposed classification and measurement approach

The IASB finalized its guidance on classification and measurement of financial assets in 2009 and financial liabilities in 2010, while the FASB has continued to develop its approach. A year ago, the FASB and IASB agreed to conduct joint discussions on the topic. Those meetings were completed earlier this year. This exposure draft represents the IASB's proposed changes to its existing guidance resulting from the joint discussions. The FASB is currently drafting its exposure draft that it plans to issue for public comment in the first quarter of 2013. A copy of the IASB's exposure draft is available on its website at www.ifrs.org.

What are the key proposals?


The proposal focuses on the accounting for debt investments. IFRS 9 currently requires debt investments to be classified and measured at amortized cost if they meet the contractual cash flows characteristics test and are held in a business model where the primary objective is to hold to collect contractual cash flows. Other debt investments are measured at fair value with changes in fair value recognized in profit or loss. Third measurement category added The proposal adds a third measurement category for debt investments: fair value with changes in fair value recognized in other comprehensive income. A debt investment will fall in this category only if it meets the contractual cash flow characteristics test and is held in a business model that is managed both to collect contractual cash flows and for sale. These instruments will follow the same impairment and interest income recognition
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

approach as debt investments measured at amortized cost. Amounts recognized in other comprehensive income will be recycled to profit or loss when the investment is derecognized. Clarification of amortized cost measurement category The proposal clarifies the primary objective of "hold to collect." Among other things, it provides additional application guidance on the types of business activities and the frequency and nature of sales that would allow debt investments to qualify for amortized cost. For example, a portfolio of debt investments that an entity would only sell in a "stress case," which is expected to be infrequent, would be consistent with the amortized cost business model. Additional guidance for the contractual cash flow characteristics test Debt investments are eligible to be measured at amortized cost under IFRS 9 if their contractual cash flows represent solely payments of principal and interest. In order to make this determination, the proposal requires an entity to assess contractual terms that could change an instrument's cash flows by reference to a benchmark instrument (i.e., an instrument with cash flows consisting purely of principal payments and compensation for the time value of money and credit risk). If the difference between the cash flows of the benchmark instrument and the instrument under assessment is more than insignificant, the debt investment will be measured at fair value with changes in fair value recognized in profit or loss.

Is convergence achieved?
The proposal focuses only on debt investments and is expected to be broadly consistent with the FASB's proposed approach. While not addressed by this proposal, the FASB and IASB also have broadly consistent approaches for financial liabilities. However, a number of differences still exist in other areas, such as the accounting for equity investments.

Who's affected?
Any entity that holds financial assets is affected by the guidance in IFRS 9. Entities in the financial services sector are likely to be most impacted by the proposal.

What's the effective date?


The proposed changes would be effective at the same time that IFRS 9 is effective, which is January 2015. The proposal would also make some changes to the IFRS 9 transition provisions. One key proposal the FASB is also considering would allow an entity to early adopt only the requirements for the presentation of fair value gains or losses attributable to changes in the issuer's own credit risk.

What's next?
The comment period for the IASBs proposal ends on March 28, 2013. The FASB is expected to issue its proposal in the first quarter of 2013. In the coming weeks we will issue a Dataline summarizing what we expect to see in that FASB proposal.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Elaine O'Keeffe Senior Manager Phone: 1-973-236-4160 Email: elaine.okeeffe@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB reaches conclusion on impairment model for financial assets measured at FV-OCI
What's new?
The FASB (the board) recently began discussing a revised impairment model for financial assets. At its September 7 meeting, the FASB made a key decision with respect to the impairment model by tentatively concluding that the current expected credit loss (CECL) model should apply to financial assets measured at fair value with changes in fair value recorded through other comprehensive income (FV-OCI). However, the FASB also decided to allow a practical expedient in applying the new model. Background Over the past several weeks, the FASB has been developing a revised impairment model for financial assets, known as the CECL model. At each reporting date, the model would require an entity to recognize a credit impairment that reflects its current estimate of credit losses expected to be incurred over the life of the financial asset. One of the remaining key decisions left to be made on the CECL model was whether the model should apply to debt securities and other financial assets measured at FV-OCI. At its most recent meeting, the FASB reached a tentative decision on this issue.

No. 2012-41 September 11, 2012

What are the key decisions?


During the meeting, there was a significant amount of discussion and varying views expressed by the board members. Ultimately, the board voted 4-3 in favor of applying the CECL model to financial assets measured at FV-OCI and establishing a practical expedient for these assets. The practical expedient would allow entities to not perform a detailed impairment analysis if both of the following conditions exist: (i) the fair value of the financial asset is greater than its amortized cost basis and (ii) the expected credit losses on the financial instrument are not significant. If either of these conditions is not present, entities would be required to perform a full impairment assessment and, if appropriate, record a credit impairment to reflect the current estimate of expected credit losses.

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Is convergence achieved?
The decisions reached to date on the CECL model do not result in convergence with the IASBs model. At this stage, the IASB has not publicly discussed any of the recent FASB decisions and whether these decisions will affect its current plan to issue an exposure draft on the three bucket impairment model in the fourth quarter of 2012.

What's next?
Over the next several weeks, the FASB plans to further discuss trade receivables, transition, and disclosure requirements. The FASBs goal is to complete all significant discussions about the CECL model by the end of September. The FASB plans to share its revised model with the IASB at that time.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB makes key decisions about the revised impairment model for financial assets
What's new?
Earlier this month, the FASB (the board) directed its staff to explore a revised impairment model for financial instruments. At its August 22 meeting, the board made some key decisions about the revised model. Background Over the past several months, the FASB and IASB have jointly deliberated a three bucket impairment model for financial assets. After considering constituent feedback, the board concluded that aspects of the three bucket impairment model are difficult to understand and present operational challenges that cannot be addressed through implementation guidance. As a result, the board decided not to move forward with an exposure draft on the three bucket approach. Instead , the board is considering a model that incorporates the concept of expected losses, but applies that concept to all financial assets and uses a single measurement approach.

No. 2012-37 August 23, 2012

What are the key decisions?


The board reached the following tentative decisions about key aspects of the revised impairment model. Estimating expected losses The model will focus on the recognition of all expected losses, which will be defined as the estimate of contractual cash flows not expected to be collected. The board decided not to establish a threshold that should be met before an entity recognizes a credit impairment. This decision will result in a change to current practice under which entities recognize all incurred losses for which it is probable that one or more future events will occur confirming the loss. When estimating expected losses, an entity will be required to consider a range of potential outcomes. The information used to develop the estimate will include: (1) a current assessment of credit risk and (2) an estimate of expected credit losses. The estimate of expected credit losses will be based on all relevant internal and external

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

information, including past events, current conditions, and reasonable and supportable forecasts. Time value of money The model will incorporate the time value of money into the measurement of expected credit losses. The FASB plans to issue guidance to communicate appropriate methods to accomplish this objective. Purchased credit impaired assets Purchased credit impaired (PCI) assets will be defined as acquired assets or acquired groups of assets with shared risk characteristics that have experienced significant credit deterioration since origination based on an assessment by the buyer. For PCI assets, entities will be required to establish an initial impairment allowance based on the level of expected losses. The impairment allowance will be updated each period with changes recognized in income immediately. The remaining non-credit purchase discount or premium will be accreted over the life of the asset.

Is convergence achieved?
The FASBs tentative decisions do not result in convergence with the IASBs model. The IASB has not publicly discussed the recent FASB decisions and whether these decisions will affect its current plan to issue an exposure draft in the fourth quarter of 2012.

What's next?
Over the next several weeks, the FASB will continue to discuss the application of the model to debt securities and assets recorded at fair value with changes in fair value recognized through other comprehensive income. In addition, the board expects to further discuss non-accrual loans, trade receivables, transition, and disclosure requirements. The FASBs goal is to complete all significant discussions about the model by the end of September. The FASB plans to share its revised model with the IASB at that time.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB decides to explore a revised impairment model for financial assets
What's new?
Over the past several months, the FASB and IASB have jointly deliberated a proposed three bucket impairment model for financial assets. After recently announcing its intent to further discuss key aspects of the model, the FASB (the board) met this morning to discuss the next steps for the project. After considering the results of outreach efforts and constituent feedback, the board unanimously agreed with concerns that aspects of the three bucket impairment model are complex and difficult to understand. As a result, the FASB will not move forward with an exposure draft on the three bucket impairment model and will instead explore a revised approach.

No. 2012-32 August 1, 2012

What are the key issues?


Under the three bucket impairment model, financial assets would initially be placed in bucket 1, where credit reserves would be established for only those assets expected to experience a loss event in the next twelve months. As credit risk deteriorates, assets would then move to bucket 2 or bucket 3, where credit reserves would be based on a lifetime of expected losses, irrespective of when the loss event is expected to occur. Key aspects of the three bucket impairment model include determining whether a loss event is expected to occur in the next twelve months, and the level of credit deterioration that requires a transfer of assets between buckets. Clearly defining these concepts proved to be difficult and raised concerns as to the understandability, operability, and auditability of the model. The board considered whether implementation guidance could adequately clarify the objectives of the model. The board concluded that even with improved definitions for the key terms, there would likely still be concern over whether the model results in credit reserves that faithfully represent the credit risk of the portfolio. As a result, the board directed its staff to explore a model that incorporates the concept of expected losses, but applies that concept to all financial assets held and uses a single measurement approach.

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Is convergence achieved?
The FASB's decision to explore a revised approach could result in an impairment model that differs from the IASBs model. During today's discussion, certain IASB members indicated that they have heard much less concern about the three bucket impairment model and therefore, plan to move forward with that approach.

What's next?
The board directed its staff to develop the new model and is hopeful that the staff will be able to leverage the discussions held to date in that process. Discussions of the new model are expected to take place over the next several weeks. The FASB plans to share its findings with the IASB in early fall. It is unclear at this time whether the IASB will move forward with an exposure draft in the near term, or whether the IASB will first consider any revised proposals from the FASB.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
John Althoff Partner Phone: 1-973-236-7021 Email: john.althoff@us.pwc.com Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


No. 2012-27 July 19, 2012

FASB announces intent to further discuss key aspects of proposed impairment model for financial assets
What's new?
On July 18, 2012, the FASB and IASB (the boards) met to discuss the financial instruments project. At the conclusion of the meeting, the FASB announced its intent to continue discussions about several key aspects of the impairment model, as well as consider the results of recent outreach efforts, prior to moving forward with an exposure draft. The exposure draft is currently expected to be released in the fourth quarter of 2012. For the past several months, the FASB and IASB have continued to refine their proposed impairment model for financial assets. At a high level, the boards have agreed on a model that evaluates financial assets for credit impairment under a three bucket approach. The level of certain reserves recorded would be expected to increase as credit deteriorates over time. See In brief 2011-52, Let's try again the impairment model for financial assets refined, for more on the three bucket approach. The FASB staff has conducted outreach with stakeholders, including preparers, users, regulators, and accounting firms, to discuss various aspects of the proposed model. As part of this process, the staff received feedback that certain key aspects of the model remain unclear. Stakeholders indicated that many of their questions might be best addressed through the issuance of additional application guidance.

What's next?
The FASB staff has developed application guidance that it intends to present to the FASB during the month of August. The FASB believes that evaluating this guidance and ensuring that constituent concerns are addressed are key steps that need to be taken prior to moving forward with an exposure draft. In response to the FASBs announcement, members of the IASB expressed concern over the potential impact the FASBs activities could have on the progress made to date on this project.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7805).
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

Authored by:
Christopher Gerdau Partner Phone: 1-973-236-5010 Email: christopher.gerdau@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-4576 Email: christopher.rickli@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB and IASB agree on a three-category financial asset classification and measurement approach
What's new?
This week, the FASB and IASB (the boards) continued their joint discussions on classification and measurement of financial assets and agreed on a three-category approach for eligible debt investments. The boards had announced in January 2012 that they would work together in an attempt to achieve a more converged solution on this important part of their broader financial instruments project. These joint discussions are nearing completion and the boards have been successful in agreeing on a substantially converged approach for debt investments. Prior to January, the boards had reached different conclusions on classification and measurement and were at differing stages of finalization. The FASB had completed most redeliberations of its 2010 proposal while the IASB had already issued its final standard (IFRS 9). However, the IASB decided in late 2011 to consider targeted amendments to that standard. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations. A complete summary of the FASB's decisions on the financial instruments project is available on its website at www.fasb.org.

No. 2012-10 May 22, 2012

What are the key decisions?


Under their respective approaches, debt investments (e.g., loans and debt securities) would be classified based on an individual instrument's characteristics (as further explained below) and the business strategy for the portfolio. However, before this week's meeting, the IASB had defined two categories whereas the FASB had defined three categories. This week, the IASB agreed to introduce a third category in which debt investments are measured at fair value with changes in fair value recognized through other comprehensive income. The FASB also agreed on a revised definition for this category. As a result, the categories for debt investments would be broadly defined as follows: Amortized cost consists of debt investments where the primary objective is to hold the assets to collect the contractual cash flows.
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

Fair value with changes in fair value recognized in other comprehensive income consists of debt investments with the primary objective of both holding the assets to collect contractual cash flows and realizing changes in fair value through sale. Interest and impairment would be recognized in net income in a manner consistent with the amortized cost category, and fair value changes would be recycled from other comprehensive income to net income when the asset is sold. Fair value with changes in fair value recognized in net income consists of debt investments that either (1) do not meet the instrument characteristics criterion or (2) meet the instrument characteristics criterion but do not meet one of the other category definitions (i.e., "the residual category"). In addition, the FASB agreed to adopt the IASB requirement for prospective reclassifications between categories when there is a significant change in business strategy, which is expected to be "very infrequent." In previous meetings, the FASB had also agreed to incorporate the following aspects of the IASB's approach: Instrument characteristics criterion. The contractual cash flows of the debt investment must represent solely payments of principal and interest in order to be eligible for the amortized cost or fair value with changes in fair value recognized in other comprehensive income categories. Bifurcation of hybrid financial instruments. Separate accounting for financial asset host contracts and embedded derivatives in hybrid financial assets would be prohibited; instead the entire hybrid financial asset would be accounted for as a single instrument. However, hybrid financial liabilities would continue to be bifurcated.

Is convergence achieved?
Most of the areas slated for joint discussion have now been concluded. While the boards have agreed on a substantially converged approach for debt investments, they do not plan on addressing all differences in their respective approaches (e.g., classification and measurement of equity investments that are not under the equity method of accounting).

Who's affected?
The final guidance will likely affect entities across all industries that hold financial instruments.

What's the effective date?


The FASB must still complete its redeliberations before deciding on an effective date. The IASB had previously decided to extend the effective date for IFRS 9 to annual periods beginning on or after January 1, 2015 (see In brief 2011-55).

What's next?
The boards are still expected to discuss some remaining issues including transition and disclosures. The FASB will also separately address a number of other matters in the coming months before issuing an exposure draft later this year. It is unclear at this time whether the new impairment approach will be included in that document or issued as a separate exposure draft.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 2

Authored by:
Greg McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Elaine O'Keeffe Senior Manager Phone: 1-973-236-4160 Email: elaine.okeeffe@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB and IASB discuss the potential for a more converged financial instrument accounting approach
What's new?
This week the FASB and IASB (the 'boards') began joint discussions on classification and measurement of financial assets and financial liabilities. The boards had announced their intent in January 2012 to work towards greater convergence on this important project. This week was the first in a series of meetings that will address a converged solution for classification and measurement. To date, the boards have worked separately on classification and measurement and are at differing stages of finalization. The FASB has completed most of its classification and measurement redeliberations of its 2010 proposal, while the IASB has already issued its final standard (IFRS 9). However, the IASB decided in late 2011 to consider limited amendments to that standard to address: (1) how its approach interacts with the insurance contracts project, (2) implementation questions that had arisen since IFRS 9 was issued, and (3) differences with the FASB's tentative approach. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations. A complete summary of the FASB's decisions on the financial instruments project is available on its website at www.fasb.org.

No. 2012-03 March 1, 2012

What are the key decisions?


Classification and measurement The boards' approaches for the classification and measurement of financial assets focus on two criteria, the individual instrument's characteristics and the entity's business model for those instruments. However, these two criteria have been defined differently by the two boards. This week the FASB decided to adopt the IASB's instrument characteristics approach. That approach requires that in order for a financial asset to qualify for measurement at other than fair value through net income (e.g., amortized cost), the contractual cash flows of the asset must represent solely payments of principal and interest. The IASB also decided to make some changes to its application guidance for this criterion.

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Impairment In addition, the boards are continuing their joint discussions to develop a new impairment approach. During this week's joint meetings, the boards discussed the model for trade receivables. Some decisions were reached, but discussions will continue.

Is convergence achieved?
The joint discussions on classification and measurement will continue over the next few months. It should be noted, however, that not all the topics where the boards have different approaches are slated for discussion. For example, the boards do not currently plan to revisit their approach to the classification and measurement of equity investments that are not under the equity method of accounting.

Who's affected?
The final guidance will likely affect entities across all industries that hold or issue financial instruments.

What's the effective date?


The FASB must still complete its redeliberations before deciding on an effective date. The IASB had previously decided to extend the effective date for IFRS 9 to annual periods beginning on or after January 1, 2015 (see In brief 2011-55), and must still decide on the effective date of a final standard on impairment.

What's next?
The boards are expected to discuss the remaining criterion for classification and measurement the business model at their next meeting. This discussion would include a consideration of whether the IASB should add a third category for debt investments measured at fair value through other comprehensive income. Among other items, the boards also plan to discuss interrelated issues for financial liabilities and the need for bifurcation of hybrid financial assets. The FASB retained bifurcation of hybrid financial assets during the redeliberations of its 2010 proposal while IFRS 9 eliminated that requirement. The boards also plan to continue their joint discussions on the impairment model in the coming months, including further developing the approach to trade receivables, purchased loans with existing credit impairment, and debt securities. The IASB plans to issue an exposure draft on its targeted amendments to IFRS 9 in the second half of this year whereas the FASB has not made any formal decisions yet about re-exposure on classification and measurement. Both boards plan to expose the new impairment approach in the second half of this year for public comment.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
Greg McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com Jivka Batchvarova Senior Manager Phone: 1-973-236-4841 Email: jivka.i.batchvarova@us.pwc.com Guido Tamm Manager Phone: 1-973-236-4171 Email: guido.tamm@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


IASB delays IFRS 9 effective date
What's new?
The IASB has issued an amendment to IFRS 9, Financial instruments, that delays the effective date to annual periods beginning on or after January 1, 2015. The original effective date was for annual periods beginning on or after January 1, 2013. The amendment is a result of the board extending its timeline for completing the remaining phases of its project to replace IAS 39, Financial instruments: Recognition and measurement, (such as impairment and hedge accounting) as well as the delay in the insurance project. In issuing the amendment, the IASB confirmed the importance of applying the requirements of all the phases of the project to replace IAS 39 at the same time. Under the current version of IFRS 9, entities that adopt IFRS 9 for reporting periods beginning before January 1, 2012 are not required to restate prior periods, while entities that adopt the standard on or after January 1, 2012 are required to restate prior periods. The amendment provides further relief from restating prior periods. However, a consequential amendment to IFRS 7, Financial instruments: Disclosures, requires additional transition disclosures when prior periods are not restated. These disclosures focus on the impact that the adoption of IFRS 9 has on the classification of financial assets and liabilities. Under the modified versions of IFRS 9 and IFRS 7, an entity that adopts IFRS 9 for reporting periods: (a) beginning before January 1, 2012 need not restate prior periods and is not required to provide the additional disclosures in IFRS 7; (b) beginning on or after January 1, 2012 and before January 1, 2013 must elect to either restate prior periods or provide the additional disclosures in IFRS 7; and (c) beginning on or after January 1, 2013 need not restate prior periods but are required to provide the additional disclosures in IFRS 7. Early application of IFRS 9 continues to be permitted.

No. 2011-55 December 21, 2011

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In brief

Is convergence achieved?
While the FASB and IASB have been working together on certain phases of the financial instruments project, the boards have been on different timetables. The effective date of the FASB financial instruments model has not yet been determined as the FASB continues to redeliberate certain aspects of the project. In addition to the delay of the effective date, the IASB has recently decided to consider making further limited amendments to IFRS 9. These amendments are intended to: address specific practical issues raised by those who have already early adopted IFRS 9; consider the interaction between the insurance project and IFRS 9; and achieve greater convergence with the FASB's proposed approach.

Who's affected?
IFRS preparers that hold or issue financial instruments will be required to adopt IFRS 9 no later than January 1, 2015. The amendment allows additional time for these preparers to comply with the new requirements and provides preparers the opportunity to determine the best timing of the adoption in light of the other aspects of the project.

What's next?
IFRS preparers should consider their timing of transition to IFRS 9, taking into consideration the revised guidance on providing comparative information. IFRS preparers should also begin preparations for providing the additional disclosures.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the National Professional Services Group.

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In brief

Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Guido Tamm Manager Phone: 1-973-236-4171 Email: guido.tamm@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

In brief An overview of financial reporting developments


Let's try again the impairment model for financial assets refined
What's new?
The FASB and the IASB (the boards) met this week and agreed on the impairment objective and measurement approach for financial assets, including loans and securities. After months of deliberations and discussions, the boards appear to have made progress in achieving convergence in the area of impairment for financial assets. These discussions are part of the boards' redeliberation efforts on the joint impairment project. All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations or issued a final standard. A complete summary of the boards decisions on the impairment model project is available on the FASB's website at www.fasb.org.

No. 2011-52 December 15, 2011

What are the key provisions?


Overview To quickly recap, portfolios of financial assets will be divided into three buckets for purposes of measuring impairment. Assets will start off in Bucket 1 and the measurement of impairment will be based on twelve months of expected losses. Assets will shift to either the second or third bucket if and when credit deteriorates. The measurement of impairment in Bucket 2 and 3 will be based on lifetime expected losses. Expected losses In previous discussions, which were affirmed during this week's meeting, the boards decided that expected losses should be estimated with the objective of an expected value. Under the expected value concept, entities will need to identify possible outcomes, estimate the likelihood of each outcome, and calculate a probability-weighted amount. The boards also decided that other appropriate methods could be used as a reasonable way to achieve the objective of an expected value. Examples of suitable methods include: (1) the loss rate method, which incorporates the probability of default and loss given default, and (2) the collateral value method. Bucket 1 The objective for the allowance provision in Bucket 1 will be to provide for an adequate reserve at the measurement date for expected losses that are anticipated to occur over the
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

next twelve months. Financial assets with insignificant deterioration in credit since origination or purchase for which entities expect to recover substantially all contractual cash flows may qualify for Bucket 1 measurement. Assets will need to be grouped in pools with similar risk characteristics or analyzed at the individual level to evaluate if they meet the Bucket 1 criteria. Buckets 2 and 3 The recognition of lifetime expected losses will be based on: (1) the extent of deterioration in credit quality since initial recognition and (2) the resulting risk of not collecting the contractual cash flows. Financial assets will be transferred to Bucket 2 or 3 when entities determine that there has been more than insignificant deterioration of credit quality since the initial recognition and it is at least reasonably possible that the cash flows may not be fully recoverable. The difference between Bucket 2 and Bucket 3 is simply a unit of evaluation difference. Bucket 2 includes financial assets evaluated collectively and Bucket 3 includes financial assets evaluated individually. Transfers between buckets The boards agreed that the impairment model will allow for migration of credit in both directions. For example, assets can transfer from Bucket 1 to Bucket 2 when credit deteriorates or vice versa if credit improves. An entity will need to evaluate and consider various factors when determining whether transfer between impairment buckets needs to occur, such as changes in general economic and industry conditions, changes in underwriting standards, and credit quality of the borrower, among others. In addition, the boards agreed that the probability of default should be the predominant characteristic for determining the collectibility of cash flows. Debt securities model The model will also be applied to debt securities. Debt securities may be evaluated individually or in the aggregate based on similar risk characteristics to determine whether the recognition of lifetime expected losses is required. A predominant indicator for credit deterioration will be changes in the security's fair value. However, the staff will continue to work on specific factors for securities that will help entities make a determination about when to transfer securities to Bucket 2. While the boards conceptually agreed on the proposed approach described above, they will continue to have discussions regarding factors and events that may trigger transfers between buckets as well as yield recognition for financial assets under this model.

Is convergence achieved?
Both boards continue to strive to achieve convergence in this area as constituents believe that achieving convergence on the impairment model is critical. The tentative decisions made this week indicate that the boards may be one step closer to achieving this goal.

What's next?
The boards' decisions are tentative and subject to change. Once the boards complete redeliberations, an exposure draft will be issued for public comment. An exposure draft is targeted for the first half of 2012.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

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In brief

Authored by:
Gregory McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Jivka Batchvarova Senior Manager Phone: 1-973-236-4841 Email: jivka.i.batchvarova@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

Dataline A look at current financial reporting issues


Financial instruments An update on the FASB's financial instruments project redeliberations as of June 30, 2011
Overview
At a glance The accounting for financial instruments is a priority joint project of the FASB and IASB. Whereas the IASB has finalized its classification and measurement approach, the FASB is in the process of redeliberating its May 2010 proposal. The FASB has made significant changes from that proposal, including requiring loans that are principally held for collection, bank deposits, and most of an entity's own debt to be classified and measured at amortized cost, and retaining the current criteria for the equity method of accounting. The FASB and IASB continue to work on developing a joint approach to the accounting for credit impairments. After considering constituent input on the different impairment approaches in their supplement document, the Boards have decided to develop a variation of the previous impairment proposals. An exposure draft of the revised impairment proposal is expected by the end of third quarter 2011. The FASBs current timeline indicates that it plans to finalize its classification and measurement and impairment approach by the end of 2011, although this may be challenging given the projects current status. The FASB has obtained feedback on the IASB's proposed revisions to hedge accounting and its own May 2010 proposal. The IASBs proposal differs significantly from the FASBs proposal in a number of ways including proposing to extend hedge accounting to components of nonfinancial instruments. The FASB plans to consider the feedback in future redeliberations that will take place later in 2011. Consequently, the FASB is unlikely to finalize its revised hedge accounting guidance by the end of 2011.

No. 2011-26 July 7, 2011 Whats inside: Overview .......................... 1


At a glance ...............................1 The main details ..................... 2

Scope ................................2 Update on redeliberations..............3


Classification and measurement ....................... 3 Impairment of financial assets ...................................13 Hedge accounting .................. 15 Disclosures ............................. 15

Questions ....................... 15

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Dataline

The main details .1 The objective of this joint project is to improve the decision usefulness of financial statements by simplifying and harmonizing the accounting for financial instruments. However, despite being a joint project, the FASB and IASB have reached different conclusions on many aspects of the project to date. Once finalized, the new guidance will replace or amend most of the FASBs and IASBs respective financial instruments guidance. .2 In May 2010, the FASB proposed changes to its standards on financial instruments accounting. That proposal included an entirely new classification and measurement model for all financial instruments, a new credit impairment model for debt instruments, and significant amendments to the guidance on hedge accounting. For a summary of the key elements of that proposal, refer to Dataline 2010-25, FASB Proposes Changes to Financial Instruments Accounting. .3 The FASB is in the process of redeliberating its May 2010 classification and measurement approach and has significantly changed course from that proposal. It has also been jointly redeliberating impairment with the IASB. The FASB aims to finalize most of the guidance by the end of 2011. The FASB must still decide on the effective date for the final standard. It has separately sought input from constituents on the effective dates and transition for all of its priority projects. PwC observation: As discussed in our recent Point of view, Finding the right pace for standard setting, we support the Boards' conclusion that more time is needed to develop final standards on the priority joint projects. We believe that completing these projects by the end of 2011 will be challenging given the amount of work that remains to be done. This is especially true for the financial instruments project, particularly as it relates to impairment. As further noted in our Point of view, we also believe that re-exposure of the FASB proposals would be beneficial and is the best way for the FASB to obtain an appropriate level of constituent input. The FASB has entirely rewritten its classification and measurement approach during redeliberations and has not to date had the benefit of constituent input. The Boards have indicated that they will seek further input through re-exposure of the impairment approach prior to finalizing that approach. .4 All FASB decisions discussed in this Dataline are tentative and therefore subject to change, as it has not yet concluded its deliberations or issued a final standard. A complete summary of the FASBs decisions on the financial instruments project is available on the FASBs website at www.fasb.org.

Scope
.5 The FASB has not redeliberated the scope of instruments to which this guidance would apply. While its May 2010 proposal used the definition of a financial instrument as its starting point, a number of exceptions were provided. PwC observation: The interplay between this guidance and the scope exceptions included in the derivatives guidance (ASC 815) is unclear, including whether an instrument that meets a scope exception under the derivatives guidance would then fall within the

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Dataline

scope of this project. In addition, the relationship between this project and the scope of the insurance project has yet to be determined. For example, it is unclear at this stage whether financial guarantees would be subject to the financial instruments project, the insurance project, or existing guidance.

Update on redeliberations
Classification and measurement .6 Whereas the FASB is in the middle of its redeliberations, the IASB has already finalized its classification and measurement guidance in the form of IFRS 9, Financial instruments. While the FASB's tentative approach diverges from the IASB's finalized classification and measurement approach, the IASB has indicated that it will give its constituents the opportunity to comment on the FASB's approach once it is closer to being finalized. PwC observation: Even though the IASB's classification and measurement approach has been finalized and allows for early adoption prior to the mandatory effective date at the start of 2013, the European Union (EU) has not yet endorsed IFRS 9 thereby precluding IFRS-reporting entities within those countries from being able to early adopt that guidance. The EU has indicated that it will only make a decision on endorsement once the entire financial instruments guidance has been finalized. At this stage it would seem that a 2013 effective date would be challenging from an implementation perspective. As a result, the IASB is expected to consider moving the mandatory effective date to the beginning of 2015 at its July 2011 meeting. In addition, some EU constituents have expressed their desire for targeted changes to be made to IFRS 9. These constituents may prefer certain aspects of the FASB's approach and will again have the opportunity to formally express their views when the IASB requests comments on the FASB's revised approach. Two examples of aspects of the FASBs approach that some may view as desirable include: (1) the ability to recognize debt investments held for liquidity or interest rate risk management purposes at fair value with changes recognized in other comprehensive income (OCI), and (2) the requirement to bifurcate embedded derivatives that are not clearly and closely related to the host contract from hybrid financial assets. Other aspects of the FASB approach however may be less appealing such as the inability to classify equity securities in the fair value through OCI category. .7 The FASB has not completed its redeliberations on classification and measurement and among other aspects must still address the scope of the project, instruments that can only be redeemed for a certain amount, the accounting for changes in fair value due to an entity's own credit, presentation, and disclosures. Subcategories for classification and measurement .8 The FASB decided that debt instrument assets are classified and measured in one of three categories: (1) amortized cost, (2) fair value with changes in fair value recognized in OCI, or (3) fair value with changes in fair value recognized in net income. The IASB approach instead requires all debt instrument assets to be classified and measured into one of two categories: (1) amortized cost or (2) fair value with changes in fair value recognized in profit or loss.

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Dataline

.9 Under both the FASB's tentative approach and IFRS 9, debt instrument liabilities are classified and measured in one of two categories: (1) amortized cost or (2) fair value with changes in fair value recognized in net income (profit or loss). .10 All equity investments not accounted for under the equity method are measured at fair value with changes in fair value recognized in net income under the FASB's approach. Comparison to IFRS 9: This is also the default treatment under IFRS 9 for equity instruments. However, IFRS 9 does allow entities to irrevocably elect on an individual instrument basis to have fair value changes for equity investments not held for trading purposes to be recognized in OCI with no impairment and no subsequent recycling to profit or loss even upon disposal of the instrument. Debt instrument assets .11 Debt instrument assets would be classified and measured into the three categories based on two criteria: (1) the individual instrument's characteristics, and (2) the entitys business activities. Comparison to IFRS 9: IFRS 9 also requires classification and measurement to be based on the business model and certain instrument characteristics. However, the similarity ends there as the IASB has defined both of those criteria very differently from the FASB's proposed model. The IFRS 9 approach for the amortized cost category is focused solely on (1) the business model (i.e., whether the objective is to hold the asset to collect the contractual cash flows) and (2) the instrument's cash flow characteristics approach (i.e., whether the instrument give rises to cash flows that constitute solely payments of interest and principal). As a result the IASB approach is focused on the business purpose for buying or originating a portfolio of assets whereas the FASB approach focuses on an entity's business activities (i.e., customer financing, investing, or trading). .12 The FASB decided to retain the current guidance to identify any embedded derivative and determine whether it should to be accounted for separately from the host contract. Any embedded derivative in a hybrid financial asset that is required to be accounted for separately (because it is not clearly and closely related to the host contract) would continue to be measured at fair value with changes in fair value recognized in net income. The instrument's characteristics and business strategy criteria would then be applied to the remaining host contract to determine its appropriate classification and measurement. Comparison to IFRS 9: IFRS 9 differs from the FASB's tentative approach in that it requires that hybrid financial assets be accounted for as a single instrument. Embedded derivatives in financial assets are no longer bifurcated. The existence of the features that do not represent solely payments of principal and interest will require the entire instrument to be measured at fair value through profit or loss. Some non-U.S. constituents may find the FASB's approach for hybrid financial assets preferable on the basis that it would reduce the earnings volatility that would result from recognizing fair value changes for the entire instrument in earnings and allow institutions to hedge the discrete risk. Criterion 1 the instrument's characteristics .13 To be eligible for classification and measurement at either amortized cost or fair value with changes in fair value recognized in OCI, all of the following criteria would need to apply to the individual debt instrument asset:

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Dataline

a. It is not a derivative subject to the derivatives guidance in ASC 815 b. It involves an amount transferred to the issuer at inception (principal adjusted for any discount or premium) that will be returned at maturity or settlement Note: The FASB suggested that the amount transferred initially could include goods or services, which means that accounts receivable and accounts payable would meet this test. c. It cannot be contractually settled or prepaid such that the investor would not recover substantially all of its initial investment other that due to its own choice PwC observation: Because most interest-only strips can be contractually prepaid such that the holder would not recover substantially all its recorded investment, few would meet this criterion. Only those that cannot be contractually prepaid (e.g., Treasury strips) could qualify. Residual interests would also fail this test. Bonds purchased at significant premiums may also be ineligible for the amortized cost or fair value with changes in fair value recognized in OCI categories due to criterion (c).

Criterion 2 the entitys business activities .14 The FASB has broadly defined three business activities: customer financing, investing, and trading activities. This differs from current guidance for investments in securities which only defines two of the three categories with the third (available-forsale) being a default category. Under the proposed model, companies would have to classify an instrument at origination or purchase based on its business activity for the portfolio and no default option could be applied. PwC observation: During redeliberations it appeared that the individual FASB members had a view on the appropriate measurement basis for individual instruments in certain circumstances. However, there is a risk that the manner in which the principles are articulated may not always achieve that intended treatment. For example, by not allowing a fair value option or fair value (with changes in fair value recognized in net income) to be the default measurement, there is a risk that certain entities which currently manage all of their financial instruments on a fair value basis and recognize fair value changes in net income would be required to recognize changes in fair value in OCI for debt instruments that are not held for sale. The FASB may still consider requiring fair value measurement in those instances (for further information see paragraph 32). .15 Debt instrument assets are classified based on the business activity used to manage those financial instruments as a portfolio (rather than the entitys intent for an individual instrument), together with the individual instrument's characteristics. An entity can manage the same or similar instruments through different business activities thereby resulting in the same instrument type being classified differently. .16 In contrast with current guidance for the amortized cost (held-to-maturity) category, the FASB decided that subsequent sales of instruments do not taint the existing portfolios classification. However, significant sales may call into question assertions on newly originated or acquired instruments. In addition, the FASB decided that if an entity subsequently decides to sell debt investments that are measured at amortized cost, then the impairment model would change from a credit impairment approach to recognizing
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Dataline

in net income the entire difference between the amortized cost basis and the fair value of those instruments. .17 The FASB also noted that an entity must classify all investments into one of the three categories even if at inception it cannot specifically identify which debt investments in a portfolio will be sold versus held under the amortized cost business strategy. PwC observation: The FASB struggled to find an approach that was operational to address the classification of portfolios of assets where a portion will be managed for collection of the contractual cash flows while the remainder will be sold or securitized, but the individual assets to be sold or securitized are not specifically identified at inception. This is not a new issue as under current GAAP many have struggled with distinguishing between the held-for-investment and the held-for-sale categories for loans, albeit that current GAAP allows for reclassifications. Ultimately the FASB noted that companies would have some flexibility because this determination would only have to be made by the end of the reporting period, by which time the instruments that will be sold or securitized may have been identified. However, that may not be the case and companies will need to make their best effort considering available information to establish the appropriate classification. Companies are unable to change their initial classification in subsequent periods under the FASB's tentative approach (for further information see paragraph 38).

Amortized cost category .18 All of the following would need to apply to a debt instrument asset classified in this category: The business strategy is to manage through customer financing (lending or borrowing) activities with a primary focus on the collection or payment of substantially all contractual cash flows. The holder of the instrument has the ability to manage the credit risk by negotiating any potential adjustment of contractual cash flows with the counterparty in the event of a potential credit loss. Sales or settlements would be limited to circumstances that would minimize losses due to deteriorating credit. PwC observation: This test is intended to limit the debt instruments classified in the amortized cost category to those that involve a direct relationship between the holder (lender) and the issuer (borrower) of the instrument. In particular, a holder of publicly-issued debt would be less likely able to manage its credit risk exposure through renegotiation than the provider of financing directly to a borrower. Meeting this criterion may also be challenging for participants in loan participation or syndication arrangements as the lead arranger is often the only party that is able to manage the borrower relationship on behalf of the other participants. However, some FASB members have suggested that an entity's participation should be eligible for amortized cost if an agent is managing the credit risk exposure of that instrument on behalf of the entity.

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Dataline

At a recent joint FASB and IASB education session, some FASB members indicated that they intend this category to capture portfolios where the primary objective is to manage the credit risk and that a secondary objective (e.g., managing interest rate risk and an entity's interest margin) should not preclude amortized cost measurement. In addition, the FASB Chairman acknowledged concerns expressed by some smaller financial institutions that this category was not sufficiently broad and noted that the FASB will continue to work on refining the categories. The instrument is not held for sale Comparison to IFRS 9: The business model for the amortized cost category is defined more broadly under IFRS 9 than the FASB's approach in that it focuses on the business strategy for originating or buying an individual financial asset (i.e., holding for collection of contractual cash flows versus selling). As a result it potentially allows more debt securities to be eligible for amortized cost than under the FASB's approach. However, a debt instrument that is being managed to maximize total return and could therefore either be sold or held for collection of the contractual cash flows would likely have to be measured at fair value with changes in fair value recognized in profit or loss. Fair value with changes in fair value recognized in OCI (fair value through OCI) category .19 All of the following would need to apply to a debt instrument asset classified in this category: The business strategy is to invest the cash of the entity either to: a. Maximize total return by collecting contractual cash flows or selling the asset

b. Manage the interest rate or liquidity risk of the entity by holding or selling the asset The instrument is not held for sale at acquisition Comparison to IFRS 9: Under IFRS 9, no debt investments can be classified and measured at fair value with changes in fair value recognized in OCI. Consequently, all debt investments would be classified into either the amortized cost or fair value with changes recognized in profit or loss categories. PwC observation: While not the FASB's intent, this broad definition could effectively cause this to be the default category for most debt instruments. This definition appears to generally require debt securities that are held in liquidity portfolios and asset liability management portfolios (which are typical in the insurance and banking industries) to be classified and measured at fair value through OCI. Insurance companies are concerned that requiring their debt investments to be classified and measured at fair value with changes recognized in OCI would create an accounting mismatch with the Board's insurance project which would require measurement changes on their insurance obligations to be recognized in net income. The FASB is aware of this concern and may consider this further as it continues to refine these categories. .20 Consistent with current accounting guidance, the FASB decided to require the recycling of gains and losses on instruments from OCI to net income that are realized due

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Dataline

to the sale or settlement of a financial asset. Also, any impairment charges would continue to be recognized in net income in the period they arise. Fair value with changes in fair value recognized in net income (fair value through net income) category .21 Either of the following would need to apply to a debt instrument asset classified in this category: The instrument is held for sale The instrument is actively managed and monitored internally on a fair value basis but does not qualify for the fair value through OCI category Comparison to IFRS 9: IFRS 9 will likely require more debt instruments to be measured at fair value with changes in fair value recognized in earnings than under the FASB's approach, mainly because it does not provide a middle category for OCI recognition of fair value changes and it may be difficult for instruments to qualify for amortized cost. Debt instrument liabilities .22 Any debt instrument liability that meets the instrument's characteristics criterion (refer to paragraph 13 for more information) would be classified and measured at amortized cost unless either of the following exists in which case it would be classified and measured at fair value with changes in fair value recognized in net income: It is held for transfer and the entity has the ability and means to transact at fair value It is a short sale PwC observation: The FASB was concerned that by applying the amortized cost business strategy tests to financial liabilities there would be unintended consequences. For example, a holder of debt obtained in the public markets is typically unable to manage its credit risk exposure through renegotiation and thus, the issuer would not have been eligible for amortized cost measurement. Therefore, the FASB concluded that it needed a different approach to financial liabilities that would retain amortized cost measurement in most instances. .23 Consistent with its decision for hybrid financial assets, the FASB decided to retain the current guidance for hybrid financial liabilities to identify any embedded derivative and determine whether it should to be accounted for separately from the host contract. Any embedded derivative in a hybrid financial liability that is required to be accounted for separately would continue to be measured at fair value with changes in fair value recognized in net income. The classification and measurement approach for financial liabilities would then be applied to the remaining host contract to determine its appropriate classification and measurement. Comparison to IFRS 9: The IASB also retained a bifurcation approach for financial liabilities. Exception for convertible debt issuances .24 The FASB has decided to provide an exception from its classification and measurement approach for issuers of convertible debt where the conversion feature is not required to be separately accounted for as equity under current guidance (ASC 470-

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Dataline

20-25-12) or separately accounted for as an embedded derivative because it qualifies for the derivative scope exception under ASC 815-10-15-74(a). The entire convertible debt instrument would then be classified and measured at amortized cost. Comparison to IFRS: Under IFRS, the debt host is eligible for amortized cost treatment after separation of the equity conversion option. The equity conversion option is either classified as equity if the instrument is convertible at a fixed amount of cash for a fixed number of shares (the fixed for fixed requirement) or recognized separately as an embedded derivative if the fixed for fixed requirement is not met. PwC observation: The treatment remains unclear under the FASBs approach for other forms of convertible debt that have an equity conversion feature that is required to be separately accounted for as equity or as a bifurcated derivative under current guidance. Specifically, it is unclear whether the host contract could be eligible for amortized cost measurement. A literal read of the instrument characteristics criterion that requires the amount transferred at inception to be returned at maturity would suggest that only the host contract of instrument C (an instrument where only the conversion spread can be settled in cash or shares while the par amount is settled in cash) would be eligible for amortized cost measurement whereas the host contract of other instrument types would not since shares and not cash could be returned to the issuer. The FASB is aware of this issue and has asked the staff to address this matter while drafting the standard.

Nonrecourse liabilities that can only be settled using specified assets .25 In situations where financial assets can only be used to settle nonrecourse liabilities, the FASB decided that the nonrecourse liabilities should be measured consistently with those financial assets. This may occur in securitization entities that are reflected in the consolidated financial statements due to failed sales or by applying the consolidation guidance for variable interest entities. Consequently, if the financial assets are measured at amortized cost then the nonrecourse liabilities would also be measured at amortized cost and would reflect an adjustment if the financial assets become impaired. Loan commitments, revolving lines of credit, and standby letters of credit .26 The FASB decided that the accounting for loan commitments, revolving lines of credit, and standby letters of credit should generally follow the accounting for the loan when funded. Therefore, they would be evaluated first under the business activities criterion. Consequently, if the loan when funded would be held for sale then the commitment would be measured at fair value with changes in fair value recognized in net income. The instrument characteristics criterion would not be applied to these instruments because the fact that they do not include an amount transferred at inception that will be returned at maturity or settlement would cause them to be measured at fair value with changes in fair value recognized in net income. .27 Instruments that do not fall into the fair value with changes in fair value recognized in net income category would be accounted for under the existing guidance (ASC 310-20), which would remain unchanged. Entities would continue to need to assess the likelihood of the commitment being drawn upon under that guidance. In situations where the likelihood of exercise is determined to be remote, then the commitment fees would be recognized as fee income on a straight-line basis over the commitment period. If the likelihood of exercise if more than remote, then the fees would be deferred and recognized over the life of the funded loan as an adjustment of yield, or if the
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Dataline

commitment is not drawn upon then the deferred fees would be recognized in net income on expiration of the commitment. Comparison to IFRS 9: Loan commitments are required to be measured at fair value with changes in value recognized in profit or loss if an entity has a past practice of selling the loans once funded. If an entity does not have a past practice of selling the loans, the loan commitments would not be carried at fair value. In these cases, the entity would need to assess if it is probable that the commitment will be exercised. Only if it is probable would the fees be deferred and recognized over the life of the funded loan as an adjustment of yield. Initial measurement .28 The FASB decided that the initial measurement of a financial instrument would follow its subsequent measurement. In other words, an instrument that will subsequently be measured at fair value with changes in fair value recognized in net income would initially be measured at fair value. An instrument that is subsequently measured at amortized cost or fair value with changes in fair value recognized in OCI would initially be recognized at the transaction price. .29 When initial measurement is at transaction price, a company would need to determine if any of the consideration given or received is for elements other than the financial instrument. If consideration relates to other elements (e.g., a credit facility offered at an off-market interest rate that compensates for services provided) then those elements should be separately accounted for under the relevant existing guidance. The FASB will continue to work on defining when an entity would need to look for other elements but has indicated that it is only looking to capture transactions that are clearly not on market terms such as when loans are extended at a zero interest rate. .30 An exception from the initial fair value measurement requirement is provided for investment companies subject to ASC 946. Those entities would continue to account for their financial instruments at transaction price including explicit transaction costs, with subsequent changes in fair value included in the fund's statement of operations as a component of unrealized/realized gains or losses on investments. Comparison to IFRS 9: Under IFRS, all financial assets and liabilities have to be initially measured at fair value. The initial fair value is normally considered to be the transaction price unless part of the consideration is for something other than the financial instrument. However, no day one gain or loss is initially recognized unless fair value is evidenced by a quoted price in an active market for the identical instrument (i.e., Level 1 in the fair value hierarchy) or based on a valuation techniques that only include data from observable markets (this day one gain or loss recognition prohibition is an existing difference between IFRS and U.S. GAAP). The fair value option .31 The FASB decided to eliminate the unrestricted fair value option that exists in U.S. GAAP today on the basis that it undermines the business strategy approach to classification and measurement. Instead, a fair value option is only provided for hybrid financial liabilities that would otherwise have required bifurcation into a host contract and embedded derivative. This option would enable an entity to measure the entire hybrid instrument at fair value and avoid the complexity of having to separately account for and measure the embedded derivative at fair value. The FASB will consider at a later date whether to allow a similar fair value option for hybrid financial assets. .32 At a later date, the FASB will consider whether to provide a fair value option or require fair value measurement for assets and liabilities that are risk managed together and their performance assessed on a fair value basis.

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Practicability exception for nonmarketable equity investments .33 The FASB decided to provide certain nonpublic entities with the ability (an option) to elect a practicability exception to the fair value measurement requirement for their nonmarketable equity investments that are not under the equity method of accounting. The FASB must still decide which nonpublic entities would be eligible for this practical exception. Comparison to IFRS 9: This practicability exception differs from the practical expedient afforded under IFRS 9, which allows measuring nonmarketable equity investments at cost on the basis that cost may approximate fair value, absent any significant changes. The FASB's practicability exception does not purport to represent fair value in any way. PwC observation: The lack of, and/or inability to obtain access to, information in order to determine the fair value of nonmarketable equity instruments that make the FASBs exception necessary would appear to apply equally to all companies, not only nonpublic entities. This challenge is exacerbated for public entities that have to determine fair values on a quarterly basis. The FASB believes that since public companies are already required to disclose these fair values, the necessary valuation processes already exist in those organizations. However, determining fair values in advance of press releases will be more challenging than determining them for disclosure purposes only. .34 Under this exception, the instrument would be measured at amortized cost less impairment but adjusted for any observable prices. The impairment approach would require a qualitative factors-based assessment to determine if it is more likely than not that the fair value is less than the carrying amount. Only if a factor(s) exists indicating that it is more likely than not that the fair value is less than the carrying amount would fair value need to be determined and, if necessary, an impairment charge recorded. The carrying amount would also need to be adjusted either up or down for any observable prices. Observable prices are those prices that represent orderly transactions for the identical or a similar asset from the same issuer. The equity method of accounting .35 The FASB decided to retain the current guidance for determining if an equity investment should be accounted for under the equity method of accounting. In its May 2010 proposal, the FASB had proposed limiting the investments accounted for under the equity method to those where the investor has significant influence over the investee and the operations of the investee are related to the investors consolidated operations. Subsequently, the FASB decided that only significant influence would be needed, consistent with current guidance. In a future meeting, the FASB will consider if additional qualitative disclosures are needed to enable users to better understand the reason for a company's investment in an entity that is accounted for under the equity method. PwC observation: Based on the feedback received on the FASB's May 2010 proposal, most companies are likely to be pleased with this decision. The May 2010 proposal could have significantly restricted the use of the equity method of accounting and required many of these investments to be measured at fair value with changes in fair value recognized in net income. .36 The fair value option would no longer be available for equity investments under the equity method of accounting.
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PwC observation: Some companies that utilize the fair value option may be unhappy with the decision to eliminate this alternative. Some have used this option to simplify their accounting where there is a readily obtainable market price or in order to achieve consistent treatment between entities within a consolidated group that invest in the same investee. However, the FASB has indicated that it may consider in a future meeting whether to instead require fair value measurement for equity investments in certain circumstances despite the existence of significant influence. .37 The impairment approach for investments under the equity method of accounting would be similar to that required for nonmarketable equity investments under the practicability exception. It would require a qualitative factors-based assessment to determine if it is more likely than not that the fair value is less than the carrying amount. Only if a factor(s) exists indicating that it is more likely than not that the fair value is less than the carrying amount would fair value need to be determined and, if necessary, an impairment charge recorded. Impairment charges taken could not be reversed at a later stage due to a recovery in value. Comparison to IFRS: IFRS (IAS 28) also requires the equity method of accounting when the investor has significant influence over the investee. However, IAS 28 does exclude venture capital entities and many funds from this requirement where they instead account for those investments at fair value with changes recognized in profit or loss in accordance with IFRS 9. PwC observation: While the FASB preferred to eliminate the need to perform an additional assessment of whether a decline is other-than-temporary, individual FASB members suggested that they would like some consideration of the extent to which fair value is below the carrying amount and how long that situation has existed before recognizing an impairment charge in net income for marketable equity investments under the equity method of accounting. However, it appears that the FASB does not want to retain the current guidance that considers the intent and ability of an entity to hold the investment until recovery. The FASB will continue to refine this impairment approach.

Reclassification .38 The FASB has reaffirmed its May 2010 proposal to prohibit reclassifications between categories after initial recognition. Comparison to IFRS 9: This decision is not convergent with IFRS 9, which does require reclassification when the business model changes. However, under IFRS 9 a change in intent (even in circumstances of significant changes in market conditions) is not a change in business model. PwC observation: The FASB does not believe it is necessary to change the measurement attribute (from amortized cost to fair value or vice versa) when the business activities for the portfolio change. Instead the FASB prefers to address a change from an amortized cost strategy to a fair value strategy through the impairment model by requiring fair value be the basis for any impairment and not only credit risk changes. This change in

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Dataline 12

impairment model is intended to ensure that losses are not deferred when an entity's strategy changes from one focused on cash flow collection to one focused on returns through sale.

Impairment of financial assets .39 The FASB and IASB are continuing to work on developing an impairment approach that would be applied to all debt instruments that are not measured at fair value with changes in fair value recognized in net income. Joint discussions to date have focused on debt instruments classified and measured at amortized cost because only the FASB's proposed classification and measurement approach would require certain debt instruments to be classified and measured at fair value with changes in fair value recognized in OCI. As previously discussed, under the FASB's proposed approach, the amortized cost category would consist predominantly of loans whereas the amortized cost category under IFRS 9 could include both loans and debt securities. In addition, the Boards have continued to focus on developing an impairment approach for open portfolios of loans. In the future they will need to consider whether that impairment approach can be applied to debt securities, closed portfolios, and individual assets. .40 The FASB and IASB had originally proposed differing impairment models that they developed separately. Many constituents that commented on those proposals emphasized the need for the Boards to develop a converged impairment approach. In January 2011, the Boards issued a joint supplementary document titled Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging ActivitiesImpairment (the "Supplementary Document") to gather input on new impairment approaches. The Supplementary Document contained three credit impairment approaches a common proposal and two alternative proposals. For a more detailed summary of these approaches, refer to Dataline 2011-09, Impairment redux FASB and IASB are seeking comments on a converged impairment model for financial assets. Respondents were generally not supportive of the Boards common proposal. PwC observation: No obvious solution has emerged from the various rounds of constituent feedback or the Boards' deliberations that balances their differing objectives with the need to have conceptual merit and also be operational. One suggested approachdeveloped by a group of U.S. banksthat has received attention proposes to expand on the current incurred loss accounting model by eliminating the probability threshold, incorporating expected events into the loss forecast, and extending the loss emergence period. Specifically, the allowance would consist of a "base component" for losses inherent in the portfolio that are reasonably predictable, plus a "credit risk adjustment component" for losses that are not yet reflected in the base component but consider macro-level indicators that are expected to emerge as the credit cycle unfolds. Many constituents are very interested in understanding the future impairment model for debt securities. Current guidance requires impairment to be assessed on an individual asset basis for debt securities given their unique nature. If the Boards adopt an approach that requires pooling of these investments in order to determine the allowance, then this would be a new concept and may be counterintuitive to some when no allowance would otherwise have been required if assessed at an individual asset level. In addition, where an entity holds only one or a few investments of the same type, it remains to be seen whether a pooling approach would require a hypothetical pool of securities to be considered in determining the allowance for those individual assets.

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Dataline 13

It is also unclear whether the FASB will develop a different impairment model for debt instruments classified and measured at fair value with changes in fair value recognized in OCI. This category is likely to include most debt securities that are not measured at fair value with changes in fair value recognized in net income. .41 Most recently in June 2011, the Boards agreed to pursue a variation of the previous approaches. Instead of splitting the portfolio into two categories as under current practice (performing and nonperforming), the new approach would divide an open portfolio into three categories: Bucket 1: Assets not affected by observable eventsThis category would consist of debt investments that have been unaffected by observable events indicating a direct relationship to a possible future default, although credit loss expectations may have changed due to macroeconomic events that are not specific to an individual asset or group of assets. An allowance for credit impairment would be a minimum of twelve months of expected losses based on initial expectations at acquisition or origination. The allowance would also include any changes in expected credit losses from those expected at acquisition or origination. Bucket 2: Assets affected by observable events (but the specific assets that will default are not identified)This category would consist of debt investments that have been affected by observable events indicating a direct relationship to a possible future default; however, the specific assets in danger of default have not yet been identified. An allowance for credit impairment would be recognized equal to the full expected lifetime losses. Since expected credit losses cannot be specifically identified for individual assets, the allowance amount would be determined at a portfolio level. Bucket 3: Individual assets expected to default or that have defaulted This category would consist of debt investments for which information is available that specifically identifies that credit losses are expected to, or have, occurred on individual assets. No default needs to have occurred for assets to be included in this category. An allowance for credit impairment would be recognized based on the full lifetime expected losses for the individual assets. PwC observation: The FASB and IASB will continue to work on refining this new approach. Some individual Board members have expressed concern that the approach for bucket 1 would be challenging for companies to implement, especially for open portfolios. In addition to determining an allowance at inception for twelve months of expected losses, the approach for bucket 1 would likely require companies to determine the expected losses over the life of the portfolio at inception in order to be able to subsequently quantify the impact of changes from those initial expectations. Constituents are likely to raise similar operational concerns as were noted on the IASB's original impairment proposal, such as how to keep track of initial expectations when loans are continually being added or removed in an open pool, or how to determine whether a subsequent change in expected losses relates to loans previously in the open portfolio or rather are due to a change in the portfolio mix as a result of adding or removing loans. Another challenge the Boards will face is clarifying when assets need to be transferred from bucket 1 to bucket 2, or whether newly originated loans could ever go directly to bucket 2.

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Dataline 14

Hedge accounting .42 Based on constituent feedback on its December 2010 hedge accounting proposal, the IASB has begun to redeliberate its approach. The FASB also gathered constituent feedback on the IASB's approach but has deferred redeliberating hedge accounting until later in 2011. For a more detailed analysis of the IASBs hedge accounting proposal and how it compares with the FASBs May 2010 proposal, refer to In Brief 2011-06, FASB seeks comments on IASB hedge accounting proposal, and Dataline 2011-06, Accounting for hedging activities A comparison of the FASBs and IASBs proposed models. PwC observation: The IASB is working toward finalizing its general hedge accounting model in the fourth quarter of 2011. In addition, the IASB has started work on a macro hedging model designed for risk management strategies such as asset and liability management at banking institutions. As a result, similar to classification and measurement, the FASB will lag behind the IASB and may reach different conclusions in its own redeliberations than those contained in the IASB's final standard. This disconnect in timing may make it challenging for the Boards to achieve a converged solution. The Boards' respective proposals differed significantly and if they continue to prefer their respective approaches, the extent of differences between the two sets of standards would increase from what exists today. In addition, while the IASB plans to issue an exposure draft on macro hedging in the fourth quarter of 2011, the FASB currently has no plans to address this concept.

Disclosures .43 The FASB intends to develop standardized tabular disclosures about liquidity and interest rate risks arising from an entity's involvement in financial instruments. While these disclosures will likely apply to banks, insurance companies, and captive finance companies, the FASB has indicated it will need to further consider the application of these disclosures to other types of entities. Other new disclosures will also be considered, for example for situations where an entity has subsequently decided to sell financial assets that are classified and measured at amortized cost.

Questions
.44 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact a member of the Financial Instruments Team in the National Professional Services Group (1-973-2367803).

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Dataline 15

Authored by:
Greg McGahan Partner Phone: 1-973-236-5250 Email: gregory.mcgahan@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Craig Cooke Director Phone: 1-973-236-4705 Email: craig.cooke@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

Dataline A look at current financial reporting issues


Accounting for hedging activities A comparison of the FASBs and IASBs proposed models
Overview
At a glance In December 2010, the IASB released for public comment an exposure draft of proposed changes to the accounting for hedging activities, resulting from the third phase of the IASB's project to revise financial instruments accounting. Comments are due by March 9, 2011. The proposed IFRS model is more principles-based than the current IASB and US GAAP models and the US GAAP proposal, and aims to simplify hedge accounting. It would also align hedge accounting more closely with the risk management activities undertaken by companies and provide decision-useful information regarding an entitys risk management strategies. The IASB plans to issue a final standard by mid-2011, with an effective date of January 1, 2013. However, the IASB recently issued a discussion paper on effective dates and transition for major projects. Its deliberations of the issues raised in the discussion paper could impact the effective date of the proposed hedge accounting guidance. The IASB's exposure draft proposes changes to the general hedge accounting model only. The macro hedge accounting principles will be addressed in a separate exposure draft, which is expected to be released in the second quarter of 2011. The FASB is planning to seek feedback from its constituents on the IASB s exposure draft. In May 2010, the FASB issued an exposure draft that proposed fundamental changes to the accounting for financial instruments, including certain changes to hedge accounting.

No. 2011-06 February 1, 2011 Whats inside: Overview .......................... 1


At a glance ...............................1 The main details ..................... 2

Key provisions .................3

Qualifying for hedge accounting ............................ 3 Discontinuation of hedging relationships ......... 6 Eligible hedged items.............. 6 Hedging instruments.............13 Presentation ...........................16 Transition and effective date ....................... 17

Questions ....................... 17

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DataLine

The main details .1 The existing guidance on hedge accounting under IFRS and US GAAP is considered highly rules-based, complex, and inflexible. The detailed rules have, at times, made achieving hedge accounting difficult, even when transactions are entered into in connection with a rational risk management strategy, and costly. Users have also found that the current hedge accounting model does not adequately portray an entity's risk management activities. .2 In the FASB's and IASB's outreach efforts, an overwhelming majority of preparers and users who provided input to the boards requested a more principles-based approach that would promote closer alignment of hedge accounting with an entity's risk management strategies. In addition, users asked for better disclosures regarding an entitys risk management activities and the effectiveness of such strategies. .3 There are currently significant differences between the existing hedge accounting rules under IFRS and US GAAP. One of the objectives of the financial instruments project is to harmonize the accounting for hedging activities under both frameworks. Despite starting as a joint project, the IASB and FASB have taken fundamentally different approaches to address the feedback received during their outreach efforts. Broadly speaking, the FASB focused on selected issues to address the concerns related to complexity and inflexibility of the hedge accounting model, while the IASB undertook a more comprehensive review of its hedge accounting model. PwC observation: The two boards have so far moved in different directions on the hedge accounting project, as they have for the first two phases of the financial instruments project (i.e., classification and measurement and impairment). This may widen the gap between the hedge accounting requirements under the two frameworks. However, given the fact that the broad objective is to reach a converged standard in this area, we expect the boards will be focusing on reconciling their differences as they complete their redeliberations. .4 The FASBs exposure draft includes, but is not limited to, the following major changes: Relaxation of the rules pertaining to the assessment of hedge effectiveness by reducing the effectiveness threshold from highly effective to reasonably effective Elimination of the short-cut method and critical terms match method as techniques to assess effectiveness Recognition of hedge ineffectiveness resulting from under-hedges of cash flows Elimination of the ability to voluntarily de-designate hedging relationships For a detailed discussion of the significant changes proposed by the FASB, refer to Dataline 2010-25 dated June 10, 2010. .5 In contrast, the following fundamental changes are proposed by the IASB: Introduction of concepts of other than accidental offset and neutral and unbiased hedging relationships, which will replace the highly effective (80% to 125%) threshold as the qualifying criteria for hedge accounting Ability to designate risk components of non-financial items as hedged items

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Dataline

More flexibility in hedging groups of dissimilar items (including net exposures) Accounting for the time value component as a cost of buying the protection when hedging with options in both fair value and cash flow hedges Prohibition of voluntary de-designation of the hedging relationship unless the risk management objective for such relationship changes Changes to the presentation of fair value hedges Introduction of incremental disclosure requirements to provide users with useful information on the entitys risk management practices .6 The IASBs exposure draft primarily provides guidance on the micro (one-to-one) hedging model with some guidance on hedges of groups and hedges of net positions. A separate exposure draft is expected to propose guidance and/or an alternative model for macrohedging strategies. Accordingly, this Dataline does not cover the existing IFRS and US GAAP differences related to macrohedges.

Key provisions
Qualifying for hedge accounting Qualifying for hedge accounting at inception .7 This is an area where both the IASB and FASB are proposing to significantly relax the current rules to allow more hedging relationships to qualify for hedge accounting. Currently, both frameworks require that the hedge must be expected to be highly effective (a prospective test) at inception and on an ongoing basis. Additionally, the relationship must be demonstrated to have actually been highly effective (a retrospective test) at each subsequent reporting date. Highly effective is defined as a bright line quantitative test of 80% to 125%. .8 Under the FASB's proposal, to qualify for hedge accounting, a company will need to demonstrate and document at inception that: An economic relationship exists between the derivative and the hedged item in a fair value hedge (or hedged forecasted transaction in a cash flow hedge) The changes in fair value (or cash flows) of the hedging instrument would be reasonably effective in offsetting changes in the hedged items fair value or variability in cash flows of the hedged transaction. The term reasonably effective is not defined and is open to judgment. Many constituents asked for more guidance on this threshold in their comment letters. The risk management objective of the hedging relationship and how effective the hedging instrument is in managing those risks. While this assessment needs to be performed only qualitatively, the proposal notes that a quantitative assessment may be necessary in certain situations. .9 The IASBs exposure draft also would eliminate the highly effective requirement. However, the IASB concluded that replacing highly effective with reasonably effective (as proposed by the FASB) would still result in the use of a quantitative threshold. Therefore, it introduced a concept of having other than accidental offsetting, neutrality, and an unbiased result as the qualifying criteria for hedge accounting. Hence, the hedge relationship should be such that it minimizes expected ineffectiveness, and should not reflect a deliberate mismatch between the hedged item and the hedging instrument. The
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objective of the IASB is to allow greater flexibility in qualifying for hedge accounting but also to ensure that entities do not systematically under-hedge to avoid recording any ineffectiveness. This is important because the IASB has retained the current guidance that only ineffectiveness resulting from over-hedges is recorded in net income. In assessing whether the hedge relationship would minimize expected ineffectiveness, an entitys risk management function would determine the expected sources of ineffectiveness and the optimal hedge ratio. Example An entity wants to hedge a forecast purchase of 100 tons of a commodity in Location A. That commodity for delivery point Location A usually trades at about 90% of the price for the exchange-traded benchmark grade of the same commodity in Location B. If the entity wants to hedge the forecast purchase of 100 tons with exchangetraded forward contracts, then a forward contract to purchase 90 tons of the benchmark grade of the commodity in Location B would be expected to best offset the entitys exposure to changes in the cash flows for the hedged purchase. Hence, a hedge ratio of 1.11:1 would minimize expected hedge effectiveness (assuming a perfect correlation between changes in the hedged item and the changes in the hedging instrument). PwC observation: The new concepts of neutrality and unbiased result may not necessarily be viewed as simplifying the accounting for hedging activities. It may simply result in the replacement of the 80% to 125% threshold with another accounting-only measure. An alternative may be to rely on risk management policies (with a requirement to have an economic relationship between the hedged item and the hedging instrument) or require that all ineffectiveness be recorded in net income (including ineffectiveness arising from underhedging).

Maintaining the hedging relationship on an ongoing basis .10 The IASBs proposal requires an entity to determine and document the optimal hedge ratio that would result in minimizing expected hedge ineffectiveness. However, the board acknowledges that this ratio may change over time due to market conditions and other factors. In such cases, the entity would determine whether the risk management objective remains the same and the hedge relationship still meets the other qualifying criteria for hedge accounting. If so, the entity is required to rebalance the hedging relationship. .11 An entity would be required to monitor the hedging relationship to ensure that the designated hedge ratio remains optimal. If circumstances lead to a change in the optimal hedge ratio, then rebalancing would be required to minimize any expected ineffectiveness. On rebalancing, any ineffectiveness of the hedging relationship is determined and recognized immediately in net income before adjusting the hedge relationship. Fluctuations around an optimal hedge ratio cannot be minimized by adjusting the hedge ratio in response to each particular outcome. Hence, in such circumstances, the change in the extent of offset is a matter of measuring and recognizing hedge ineffectiveness (i.e., it does not result in rebalancing). Example Assume an entitys risk management function has originally determined an optimal hedge ratio of 0.9. In arriving at that ratio, the risk management function performed a regression analysis. Fluctuations in the originally determined optimal hedge ratio do not require rebalancing. However, if it is determined that there is a new trend that

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Dataline

would lead away from that hedge ratio, then a new ratio would result in minimizing ineffectiveness. In such a case, rebalancing would be required. .12 Rebalancing is a continuation of the hedging relationship. That is, the hedge is not reset by de-designation and re-designation, and hence does not require setting up a new hypothetical derivative or amortization (in the case of an interest rate hedge) of an effective portion of fair value changes to net income. The IASBs proposal permits rebalancing to be effected by increasing or decreasing the volume of the hedged item or hedging instrument in the relationship. PwC observation: The risk management function may not necessarily adapt the hedging relationship to reflect an optimal hedge ratio on a regular basis. Therefore, having a requirement to rebalance will likely add unnecessary burden on the entity. This can be a cumbersome process and may be viewed as negating the objective of simplifying hedge accounting. Frequency and nature of effectiveness tests .13 The FASBs proposal would change the existing requirement to test the effectiveness on a quarterly basis to a requirement to test only if circumstances suggest that the hedging relationship may no longer be effective. The IASB, on the other hand, proposes to retain the periodic assessment criterion (at least at each reporting date or when circumstances change). However, under both proposals, the effectiveness test is only a forward-looking test (i.e., no retrospective test would be required). .14 Like the FASBs proposal, the IASBs exposure draft would allow an entity to demonstrate effectiveness qualitatively or quantitatively, depending on the characteristics of the hedging relationship. For example, in a simple hedge where all the critical terms match, a qualitative test might be sufficient. On the other hand, in highly complex hedging strategies, some type of quantitative analysis may need to be performed. Measuring ineffectiveness .15 Currently, for cash flow hedges, both frameworks require performing a lower-of test to determine the effective portion of the hedge. Only the amount of ineffectiveness related to any over-hedges (i.e., where the cumulative changes in fair value of the hedging instrument over-compensates those of the hedged item) is recorded in net income. The IASBs exposure draft has retained this lower-of test. However, under the FASBs proposal, any ineffectiveness, whether resulting from over- or under-hedges, would be recognized in earnings. A significant number of respondents to the FASB's exposure draft expressed concern over the requirement to record all ineffectiveness, whether resulting from over- or under-hedges. .16 In addition, the IASBs proposal requires that, in measuring ineffectiveness, entities should take into consideration the impact of the time value of money on the hedged item. PwC observation: The IASB staff believes that this is not a change in guidance, and hence should not have any practical implications. However, this may affect hedges involving forward contracts. Currently, in practice, many entities separate the forward points from the forward contract and designate only the spot element as the hedged risk. The spot is not discounted; hence, the impact of the timing of cash flows is ignored, which is a critical factor in rolling strategies and partial-term hedges.

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Dataline

Discontinuation of hedging relationships Voluntary de-designation .17 Currently, the hedge accounting guidance under both frameworks allows an entity to voluntarily de-designate the hedging relationship. However, the proposed IASB and FASB models restrict entities from voluntarily de-designating the hedging relationships. .18 Under the FASBs proposal, an entity would only be able to discretionarily discontinue hedge accounting by entering into an offsetting derivative instrument or by selling, exercising, or terminating the derivative instrument. If an entity enters into an offsetting derivative instrument for purposes of discontinuing the hedging relationship, the derivative must be expected to fully offset future fair value changes or cash flows. In addition, the entity must concurrently document the effective termination of the hedging relationship. In such an event, neither derivative instrument could be designated as a hedging instrument in a subsequent hedging relationship. .19 In contrast, the IASB's proposal allows termination of the hedging relationship only if it is no longer viable for risk management purposes, or the hedging instrument is sold, expired, exercised, or terminated. PwC observation: This may result in the use of some commonly used strategies being discontinued for example, an entity hedging the foreign currency risk of forecasted foreign currency sales. Once the sale and the related receivable are recognized, the fair value changes of the derivative and the receivable would achieve a natural offset. Thus, it is common to discontinue hedge accounting at that point. However, under the IASB's proposal, this would no longer be possible. The FASBs proposal to remove the ability to voluntarily de-designate a hedging relationship lacked support from those who responded to the exposure draft. Whether the IASB will receive support from its constituents remains to be seen.

Eligible hedged items .20 Overall, the IASBs proposal provides greater flexibility in the designation of exposures as hedged risks. It will allow designating risk components of non-financial items and groups of dissimilar items (including net exposures) as hedged items. The following table provides a summary of the key changes introduced by the IASBs proposal and a comparison with the current and proposed US GAAP:
Hedged item Components of nonfinancial items Current and proposed US GAAP Prohibited Current IFRS Prohibited Proposed IFRS Permitted if the risk component is separately identifiable and reliably measurable Permits hedging a synthetic risk exposure

Derivatives

Derivatives cannot be designated as hedged items

Similar to US GAAP

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Hedged item Groups of similar items

Current and proposed US GAAP Permitted only if fair value change for each individual item is proportional to the overall change in the groups fair value Not permitted, except when hedging with internal derivatives in limited circumstances, as discussed in paragraph 39 below. Layers are permitted for cash flow hedges. Hedges of bottom layers or last of are not allowed.

Current IFRS Similar to US GAAP

Proposed IFRS Designation permitted without regard to the fair value changes of the individual items Permitted with certain restrictions

Groups of dissimilar items (net positions)

Not permitted

Layers, including bottom layers and layers of groups of items

Similar to US GAAP

Permits hedges of layers, including bottom layers for fair value hedges

Hedging risk components of non-financial items .21 Currently, the FASB and IASB allow hedges of components for financial items only. However, the IASB's proposal permits entities to hedge risk components for nonfinancial items, provided such components are separately identifiable and reliably measurable. This is an area of significant interest for risk management functions in nonfinancial service organizations. .22 In assessing whether a risk component of a non-financial item is eligible for designation as a hedged risk, an entity would take into consideration factors such as: The particular market structure to which the risk relates and where the hedging activity takes place Whether the risk component is a contractually specified component (where the contract entails a formula-based pricing structure (e.g., commodity A plus a margin) Example Entity A has a long-term supply contract for natural gas that is priced using a contractually specified formula that references commodities (e.g., gas oil, fuel oil) and other factors such as transportation charges. Entity A can hedge the gas oil component in the natural gas supply contract using a gas oil forward contract. Whether the risk component is implicit in the fair value or cash flows of the item (non-contractually specified risk components, for example, where the contract includes only a single price instead of a pricing formula) Example Entity A buys jet fuel for its consumption and is therefore exposed to changes in the price of jet fuel. Entity A can hedge the crude oil component of its forecast jet fuel purchases with crude oil forward contracts. Even though crude oil is not contractually specified in the pricing of the jet fuel, Entity A concludes that there is a relationship between jet fuel prices and crude oil prices. The relationship results from different refining margins that allow the entity to look at the hedging
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relationship as a building block and consider itself exposed to two different risks, the crude oil price and the refining margins. PwC observation: The ability to hedge risk components will be welcomed by many companies that may not have been able to achieve hedge accounting in this area for the reasons discussed above. It will be easy to demonstrate that the risk component is separately identifiable and reliably measurable when it is contractually specified; however, this may prove more challenging outside the contractually specified area. For example, brass comprises copper, zinc, and conversion costs. An entity may wish to hedge the copper component of its fixed-price brass purchases with a copper forward contract. However, the fair value movements of the brass component may be partially offset by the fair value movements of zinc (because copper and zinc are impacted by different demand curves). This may indicate ineffectiveness that will not get measured if an entity concludes that the hedge of the copper risk component with a copper forward was perfectly effective. We believe that is an area where further outreach may be required to ensure that the principles are operational and any ineffectiveness can be appropriately measured and recorded.

Derivatives as hedged items .23 Currently, derivatives are not permitted to be designated as hedged items under both IFRS and US GAAP. The FASB's proposal would not change this. However, the IASB has proposed permitting designation of aggregate exposures resulting from a combination of a derivative and another exposure (a synthetic position). This is generally the case when entities seek to manage risk on a layering basis. Example Entity A has a USD functional currency. It entered into a 10-year fixed-rate financing denominated in EUR. At the inception of the financing, the entitys risk management objective is to have a fixed-rate exposure in its functional currency for the first three years and a floating rate exposure thereafter. Hence, the entity enters into a 10-year fixed-to-floating cross currency interest rate swap ("CCIRS") at the time the debt is issued. This would swap the fixed-rate debt with a variable-rate exposure in the functional currency of the entity. Under the proposal, the entity can hedge the combined exposure (synthetic variable debt exposure created as a combination of the fixed-rate debt with the fixed-to-floating CCIRS) with a three-year floating-to-fixed interest rate swap to have a fixed-rate exposure in USD for the first three years. Groups of items .24 Currently, IFRS and US GAAP allow hedges of groups of items only if all items within the group are subject to similar risks and if changes in the fair value of each individual item are proportional to the overall change in fair value of the group. In addition, IFRS allows a fair value hedge of interest rate risk in a portfolio of dissimilar items. The IASB is proposing significant changes in this area to provide better alignment of the accounting with risk management strategies. The FASB, on the other hand, has not proposed any changes affecting groups of items as eligible hedged items. .25 The IASB's proposal would allow hedges of: (1) groups of similar items without a requirement that the fair value change for each individual item be proportional to the overall group (e.g., hedging a portfolio of S&P 500 shares with an S&P 500 future) as well as (2) groups of offsetting exposures (e.g., exposures resulting from forecast sale and purchase transactions).

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.26 However, the IASBs exposure draft stipulates additional qualifying criteria for such hedges of offsetting exposures. These include: The group should consist of items that are eligible as hedged items on an individual basis. The items in the group are managed together for risk management purposes. In the case of a cash flow hedge of net exposures, any offsetting cash flows within the group should affect net income in the same reporting period (including, any interim reporting periods). Example Assume an entity is forecasting purchases of inventory and sales of GBP150 and GBP100, respectively. The entity will only be allowed to hedge the net exposure of 50 if both the purchases and sales are expected to affect net income in the same reporting period. PwC observation: The ability to hedge net exposures is in line with common risk management practices and would remove the need to identify specific gross cash flows (e.g., a specific amount of sales that matches the net open position), which is currently required under IFRS. However, the requirement for the hedged items in the net position to affect net income in the same period would limit the use of net position hedges. As a result, this change may not provide as much flexibility as many companies expected. .27 Further, for net position hedges the IASBs exposure draft specifies that the impact of the hedge should be reflected as a separate line within the income statement. For example, if an entity is hedging sales and cost of sales, the impact of the hedge would be shown as a separate line after the sales and cost of sales lines. Example Assume an entity with a EUR functional currency has sales of USD 100 and expenses of USD 80 (both forecasted in three months) and wants to hedge against the fluctuations in exchange rates. It hedges USD 20 with a forward contract at a rate of 1.33, accordingly locking its margin at EUR 15. The spot rate on settlement is 1.25, which gives a loss on the forward of EUR 1. The following table depicts how the proposed IFRS presentation would compare with how a similar hedge is reflected under current IFRS:
Existing accounting (Reflect the hedge impact only on the gross identified position) 79 64 15 Proposed IFRS accounting (Reflect hedge impact as a separate line) 80 64 (1) 15

Hedged item Sales Expenses Hedge result Operating profit

The presentation under current and proposed US GAAP would be similar to the existing accounting under IFRS in a hedge of a percentage of gross revenue. However, if internal derivatives are used, then a gross presentation would be allowed and the hedge impact would be reflected in each of the sales and expenses lines.

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PwC observation: Showing the hedge impact separately does not necessarily reflect the risk management strategy for the items that are hedged. Risk managers typically view all items within the net position as hedged, and hence may like to present those items at the hedged rate. However, presentation at the hedged rate would not be permitted by the IASBs proposal.

Hedges of layers .28 Currently, IFRS and US GAAP allow cash flow hedges of a proportion (percentage) or a portion (layer) of a specific item or groups of items. However, in the case of a fair value hedge, this is restricted to a proportion of specific items (including groups). If a layer approach is used, the layer should be identified in the relationship with sufficient specificity so that when the transaction occurs it is clear whether that transaction is or is not the hedged transaction. The FASB has not proposed any changes in this area. .29 The IASB, on the other hand, has proposed to permit more flexibility in this area. Hence, an entity would have the ability to enter into a fair value hedge for a percentage or a portion of the specific item or groups of items without many restrictions, such as, hedges of the bottom layer of a fixed-rate debt. However, if an item includes a prepayment option, a layer of such item is not eligible to be designated as a hedged item in a fair value hedge if the options fair value is affected by changes in the hedged risk. For example, a layer component of a prepayable debt cannot be a hedged item. Other differences .30 In addition, there are numerous other differences between existing IFRS and US GAAP related to the designation of hedged items that have not been addressed by the recent proposals. Some of the key differences are discussed below:
Hedged item Components of financial items Current and proposed US GAAP Permitted for benchmark interest rate, credit risk, and foreign exchange risk. Benchmark is restricted to US government borrowing rates and LIBOR. Not permitted Current and proposed IFRS Permitted; definition of benchmark is not restricted

Partial-term hedging (fair value hedges) Hedging more than one risk with a single derivative Hedges of intragroup royalty

Permitted

Not permitted, except for basis swaps Permitted

Permitted

Permitted only if the royalty payments are linked to an external transaction

Hedging risk components of financial items .31 IFRS permits any risk components of financial instruments to be eligible hedged items, provided the types of risk are separately identifiable and reliably measurable. In contrast, current (and proposed) US GAAP specifies that the designated risk must be the changes in one of the following: (1) overall fair value or cash flows, (2) benchmark interest rates, explicitly limited to specified benchmark interest rates (interest rate on

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treasury obligations of the US federal government or LIBOR in the United States and comparable rates for non-US instruments), (3) foreign currency exchange rates, or (4) credit risk. Additionally, practice has developed in the United States such that measurement of benchmark interest rates is very restrictive. The IFRS model is therefore already more flexible in this area than US GAAP. .32 The calculation of ineffectiveness also differs in this area between IFRS and US GAAP. For example, when hedging a fixed-rate debt for changes in benchmark interest rate, US GAAP (existing and proposed) requires that the fair value of the hedged item be determined using the contractual interest rate. This results in ineffectiveness recorded in income. IFRS, on the other hand, allows using the swap rate for calculating the fair value of the hedged risk. This difference is illustrated in the following example: Example Assume an entity issues a fixed-rate debt instrument at 7%. The swap rate on a receive fix-pay LIBOR swap is 5% at issuance date. The entity designates the swap as a hedging instrument in a fair value hedge of changes in LIBOR in the fixed-rate debt. Under IFRS, the designated hedged risk is the swap rate of 5%; therefore, effectiveness is assessed, and ineffectiveness is measured, with reference to the 5% portion of the total 7% fixed rate. Under US GAAP, the cash flows used to calculate ineffectiveness must be based on the contractual cash flows of the entire hedged item (unless the shortcut method is used). Therefore, while the designated risk is a benchmark interest rate, effectiveness is assessed and ineffectiveness is measured with reference to the contractual 7% fixed rate; as such, ineffectiveness will arise. .33 A significant number of respondents to the FASB's financial instruments exposure draft expressed concern that the definition of "benchmark" is very restrictive. Respondents requested that the FASB expand the definition, especially in light of the fact that the short-cut method would be eliminated. Partial term hedging .34 IFRS is more permissive than US GAAP with respect to a partial-term fair value hedging relationship. It permits designating a derivative as hedging only a portion of the time period to maturity of a hedged item, if effectiveness can be measured reliably and the other hedge accounting criteria are met. Example Entity A acquires a 10%, fixed-rate government bond with a remaining term to maturity of 10 years. Entity A classifies the bond as available for sale. To hedge itself against fair value exposure on the bond associated with the first five years of interest payments, Entity A acquires a five-year, pay-fixed/receive-floating swap. The swap may be designated as hedging: The fair value exposure of the interest rate payments for five years The change in value of the principal payment due at maturity to the extent affected by changes in the yield curve relating to the five years of the swap In other words, IFRS allows imputing a five-year bond from the actual 10-year bond. US GAAP does not permit defining the hedged risk in a similar way.

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Hedging multiple risks with a single hedging instrument .35 IFRS allows a single hedging instrument to be designated as a hedge for more than one type of risk, provided that: The risks hedged can be identified clearly The effectiveness of the hedge can be demonstrated It is possible to ensure that there is specific designation of the hedging instrument and different risk positions Accordingly, under IFRS, a single derivative may be separated into two components by inserting (hypothetical) equal and offsetting legs, provided that they are denominated in the entitys own functional currency. US GAAP, however, does not permit creation of hypothetical components in a hedging instrument, and hence does not allow such a hedging strategy (except in a cash flow hedge using a basis swap). The following example illustrates a situation in which hedge accounting would be permitted under IFRS but not under US GAAP. Example Entity As functional currency is EUR, and it wishes to hedge the following two items with one swap as the hedging instrument: Hedged items: (1) 10-year, 5%, fixed-rate USD borrowing and (2) 10-year, sixmonth LIBOR + 80 bp loan receivable denominated in Swiss francs (CHF). Hedging instrument: 10-year cross-currency interest rate swap (CCIRS) under which Entity A will receive fixed interest in USD and pay variable interest in CHF at six months LIBOR (the rate representing a six-month interbank deposit in CHF). For IFRS, a single swap may be separated by imputing hypothetical equal and offsetting legs. These legs may be fixed or floating, provided either one of the alternatives qualifies for hedge accounting. In addition, IFRS does not necessarily require the two hedge relationships to be of the same type; as such, an entity could have two different hedge relationships (i.e., a cash flow and a fair value hedge). In this example, the original CCIRS may be separated in either of two ways:
Hedging instrument Hedged item Hedge type

ALTERNATIVE A: INSERT EUR FLOATING LEGS TO THE SWAP Receive fixed USD/pay floating EUR Receive floating EUR/pay floating CHF Currency and interest rate risk on USD debt Currency risk of CHF loan receivable Fair value hedge of interest rate and currency risk Cash flow hedge of currency risk

ALTERNATIVE B: INSERT EUR FIXED LEGS TO THE SWAP Receive fixed USD/pay fixed EUR Receive fixed EUR/pay floating CHF Currency risk on USD debt Currency and interest rate risk of CHF receivable Cash flow hedge of currency risk Cash flow hedge of interest and foreign currency risk

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Hedging intragroup royalty .36 Under current US GAAP, forecasted intragroup royalty payments are sometimes hedged in cash flow hedge relationships. While the FASB proposal issued in 2008 had proposed some changes in this area, the financial instruments exposure draft issued in May 2010 did not include any changes. IFRS is currently viewed as more restrictive in allowing such a hedging relationship. Under IFRS, forecasted intragroup royalty payments are not allowed to be designated as hedged items unless there is a related external transaction. The IASBs proposal carries forward this guidance without any changes. .37 This is a significant difference between the proposed IFRS and the practice that has developed in the United States. The FASBs 2008 exposure draft, which was viewed by many as potentially limiting the ability to hedge forecasted intragroup royalties, did not receive support from the respondents. Hedging instruments .38 The IASB's proposal entails allowing cash instruments, which are classified at fair value with changes in fair value recognized in net income (referred to in IFRS as fair value through profit or loss), to be eligible for hedging different types of risks. Currently, under IFRS, cash instruments are restricted to the hedges of foreign exchange exposures only. In addition, the IASB's exposure draft includes significant changes to the accounting for the time value of options. These proposals are discussed in more detail in the following table:
Instrument Cash instruments Current and proposed US GAAP Current IFRS Proposed IFRS Instruments classified at fair value through profit or loss are permitted to be used as hedging instruments for all types of risks. Debt instruments classified at amortized cost can be hedging instruments for foreign exchange risk only. Implications Proposed IFRS allows greater flexibility in designating cash instruments as hedging instruments

Permitted only for Permitted for hedging foreign hedging foreign exchange risk in exchange risk limited circumstances

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Instrument Embedded derivatives

Current and proposed US GAAP Permitted under current US GAAP if embedded derivative is bifurcated Not permitted for hybrid financial instruments under proposed US GAAP (since embedded derivatives are no longer bifurcated from financial hosts)

Current IFRS Similar to current US GAAP

Proposed IFRS Not permitted for embedded derivatives in hybrid financial assets under IFRS 9 (since they are no longer bifurcated)

Implications This change results from the proposed amendments to the classification and measurement of financial instruments. Under current IFRS, embedded derivatives bifurcated from hybrid financial liabilities can still be designated as hedging instruments. Embedded derivatives bifurcated from non-financial hosts would also remain eligible as hedging instruments.

Options

Current US GAAP permits time value for certain qualifying cash flow hedge relationships to be deferred in OCI and subsequently released into net income. Proposed US GAAP is similar to current guidance, except that it requires amortization of the time value component over the life of the hedging relationship.

The time value component of an option is marked to market through net income, resulting in income statement volatility.

Any time value paid is treated similar to an insurance premium for both fair value and cash flow hedges.

Proposed IFRS may yield a comparable result to the current US GAAP treatment for several transactions. However, the Accounting for the proposed IFRS premium depends model would apply on whether the to fair value and hedged item is cash flow hedge transaction or relationships time related. (proposed and current US GAAP Subsequent models are limited changes in time to certain cash flow value are hedge relationships deferred in OCI. only).

Internal derivatives

Permitted for foreign Not permitted exchange risk only in limited circumstances

Not permitted

Current US GAAP is more flexible in this area. The IASBs proposal does not include any changes in this area.

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Accounting for the time value of options .39 Under US GAAP for certain qualifying cash flow hedge relationships, the time value component of a purchased option can be deferred in OCI and subsequently released to net income when the hedged item affects net income. The FASB proposal would require that such changes be taken to income rationally over the term of the hedging relationship. .40 Currently, IFRS allows only the intrinsic value of the option to be designated as the hedging instrument, while the time value is marked to market through net income. The IASBs proposal introduces significant changes to the guidance related to the accounting for the time value of options. It analogizes the time value to an insurance premium. Hence, the time value would be recorded as an asset on Day 1 and then released to net income based on the type of item the option hedges. For example, if the hedge is for a forecasted purchase of inventory (i.e., it is transaction related), the option premium would be recognized in income when the hedged item affects net income. However, if the entity is using options to cap interest payments on a debt instrument, the premium would be recognized in earnings on a time proportion basis (time related). Any changes in the fair value of the option attributable to the time value would be recorded in OCI (along with changes in intrinsic value). The proposed IFRS treatment would also apply to fair value hedges. PwC observation: Overall this will be a welcome change for many IFRS preparers, and may result in an increased usage of purchased options in hedge accounting since the income statement volatility of the time value can now be avoided. However, prescribing two different methods to record the initial option premium may introduce unnecessary complexity. Another approach could be to require recognition of such premium in net income when the hedged item affects net income, rather than based on the type of hedging relationship. This approach would be consistent with the current US GAAP model for cash flow hedges.

Internal derivatives .41 Under current and proposed IFRS, only instruments that involve a party external to the reporting entity can be designated as hedging instruments. As internal derivative contracts are eliminated in consolidation, they do not qualify under IFRS for hedge accounting in the groups consolidated financial statements. The restrictions under IFRS compel entities to either: Enter into separate third-party hedging instruments for the gross amount of foreign currency exposures in a single currency rather than on a net basis (as a typical treasury center would do to hedge group exposure) Enter into hedging instruments with third parties on a net basis and designate such contracts as a hedge of a portion of one of the gross exposures The gross approach may not be desirable given the cost of entering into multiple external derivative contracts. The IASB is not proposing any changes in this area. .42 Similar to IFRS, US GAAP generally permits only those instruments that involve an unrelated external party to be eligible as hedging instruments. However, US GAAP permits internal derivatives in cash flow hedges of foreign currency risk if certain conditions are met. These include: All the criteria for hedge accounting are met by the entity with the hedged exposure

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The treasury center must either: (a) Enter into a derivative contract with an unrelated third party to offset the exposure that results from the internal derivative, or (b) If certain additional conditions are met, enter into derivative contracts with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative contracts PwC observation: The issue was discussed by the IASB while developing the exposure draft; however, the board decided not to allow internal derivatives to be used as hedging instruments because these do not mitigate the risks of the consolidated group. Additionally, the board believes that changes in the guidance related to net positions will, in part, help the issues that treasury centers may face from not having the ability to use internal derivatives.

Presentation Fair value hedges .43 Currently, both IFRS and US GAAP require a basis adjustment to the hedged item for changes in fair value attributable to the hedged risk. This results in the measurement of the hedged item on a basis that neither represents fair value nor amortized cost (unless the hedge is designated as hedging the total changes in fair value of the hedged item). The FASB has not proposed any changes to these requirements. However, the IASB proposal would remove the requirement to adjust the basis of the hedged item. Instead, fair value changes attributable to the hedged risk would be presented as a separate line item in the balance sheet. A corresponding entry would be recorded in OCI on a gross basis. Any ineffectiveness in the hedging relationship would then be recycled to net income. Example Assume an entity has a fair value hedge of foreign exchange risk in a firm commitment to purchase machinery from a UK supplier. The fair value change on the forward contract to hedge the purchase is USD 60, whereas the fair value change on the hedged item related to the hedged risk is USD 50. Currently, under both IFRS and US GAAP, the fair value movements on the hedged risk and hedging instrument are reflected in the income statement. Additionally, there is a basis adjustment of 50, which would affect the hedged item. The following presentation would be required under the IASB proposal:

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Balance sheet (extract) Assets Machinery Basis adjustment (separate line) Liabilities Derivative liability Other comprehensive income Changes in fair value of hedging derivative Changes in fair value of hedged item Ineffective portion transferred to net income Income statement Ineffective portion of FV hedge

50

Debit

60

Credit

(60) 50 10

Debit Credit Credit

(10)

Debit

Mandatory basis adjustment Cash flow hedges .44 In addition, for hedges of forecasted purchases of non-financial assets (e.g., a depreciable asset), the IASB has proposed a mandatory basis adjustment of the hedged item once it is recognized. Accordingly, fair value changes of the hedging instrument deferred in OCI would be adjusted against the value of the hedged item on its initial recognition. Currently, IFRS provides a choice to adjust the basis of the hedged item or continue to defer the fair value changes in equity and release them to net income when the hedged item affects net income. Current and proposed US GAAP prohibits adjusting the basis of the hedged item and requires the fair value changes deferred in OCI to be released out of OCI. Example Assume that an entity is hedging the foreign currency risk in the forecasted purchase of machinery using a forward contract. There is a cumulative gain of 100 on the derivative deferred in equity at the date the machinery is purchased. If the price paid for the forecasted purchase of machinery is 500, the initial amount recognized on the balance sheet under current IFRS will be 400 (500 less 100) when the basis adjustment policy is elected. Under the proposed IFRS model, the machinery would be recorded at 400 (mandatory basis adjustment). Under the current and proposed US GAAP, the machinery must be recognized at 500 with the 100 gain deferred in equity and released to net income when the hedged item affects net income. Transition and effective date .45 The IASB has proposed that the new requirements be applied prospectively for accounting periods beginning on or after January 1, 2013, with earlier application permitted. The FASBs proposal also requires prospective application but does not specify an effective date. It is also pertinent to note that both boards have issued discussion papers on effective dates and transition for their major projects. Their deliberations of the issues raised in those discussion papers could impact the effective date of the proposed hedge accounting guidance.

Questions
.46 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

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Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Naveed Rafique Director Phone: 1-973-236-4019 Email: naveed.rafique@us.pwc.com Steve Halterman Director Phone: 1-973-236-4179 Email: steven.g.halterman@us.pwc.com John Liang Director Phone: 1-973-236-5618 Email: john.liang@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. [FP120610] To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

DataLine
A look at current financial reporting issues PricewaterhouseCoopers 201034 August 26, 2010

Changes to Financial Instruments Accounting


Impacts for Nonfinancial Services Companies
What's inside:
Overview ............................. 1
At a glance ................................ 1 The main details........................ 1

Overview
At a glance
The FASB's proposal to change the accounting for financial instruments and hedge accounting could have broad implications to companies across all industries, including those in commercial and industrial industries. The proposed changes could result in a significant expansion of the use of fair value. Such changes would require greater valuation expertise and result in increased earnings volatility in many cases. Common instruments including investments in equity and debt instruments, accounts receivable and issuances of convertible debt, among others, would be affected. Companies should consider evaluating the impacts of the proposed changes now and consider responding to the FASB on this very important proposal.

Key provisions ..................... 1


Investments in equity instruments ............................. 1 Equity method of accounting .............................. 2 Investments in debt instruments ............................. 2 Accounts receivable factoring .................................. 3 Issued convertible debt ............. 3 Embedded derivatives............... 3 Hedge accounting ..................... 4

Next steps............................ 4 Questions ............................ 4

The main details


.1 On May 26, 2010, the FASB issued a proposed Accounting Standards Update (ASU), Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, setting out a new comprehensive approach to financial instruments classification, measurement, and impairment and proposing revisions to hedge accounting. .2 While the effects of the proposal on the financial industry are wide-ranging, its impact to the corporate community (i.e., nonfinancial services companies) is broader than the changes to hedge accounting and should not be overlooked.

Key provisions
.3 Following are a few of the more common instruments and transactions that could be affected if the proposed ASU is adopted in its current form.

Investments in equity instruments


.4 Today, investments in equity instruments that do not result in consolidation of the investee can be accounted for under one of four models: Fair value through earnings Fair value through other comprehensive income (OCI)

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1 PricewaterhouseCoopers LLP

DataLine 2010-34
The cost method The equity method .5 Under the proposed model, companies with investments in equity instruments, including equity investments in private companies, options to purchase private company shares, and mutual funds, will be required to account for such investments at fair value with changes in fair value recorded in current period earnings, unless an investment qualifies for the equity method of accounting (see below). This will result in (1) a greater need for valuation expertise since many of these investments may have previously been carried at cost, (2) timely valuations since fair values will need to be reflected in each interim and annual set of financial statements, and (3) greater earnings volatility since the changes in the fair value of these investments will be recorded in earnings. .6 For companies with equity investments in private companies this may prove to be particularly challenging both from an accounting and operational perspective.

Equity method of accounting


.7 The equity method of accounting is currently appropriate for investments in common stock or in-substance common stock where the investor has significant influence over the investee. It is also applicable to investments in partnerships where the investor's influence is considered more than "minor." .8 The proposed model will limit the use of the equity method to investments over which the investor has significant influence and where operations of the investee are considered related to the investor's consolidated operations. The proposed ASU provides factors to consider in determining whether operations of an investee are considered "related to the investor's consolidated operations." These factors may not capture certain investments considered by preparers of financial statements to be related to the consolidated operations or strategic. The addition of this criterion will reduce the number of investments that currently qualify for equity method treatment. .9 Equity investments no longer qualifying for equity method treatment will be required to be recorded at fair value with changes in fair value recorded in current period earnings. This may be particularly challenging from an operational perspective since the fair value information will need to be available on a quarterly basis (the 90-day lag period currently available for the equity method of accounting will not be available).

Investments in debt instruments


.10 Investments in debt instruments will be required to be recorded at fair value through earnings unless certain criteria are met. One of these criteria requires that an entity's business strategy be to hold the debt instrument for collection of contractual cash flows rather than to sell the instrument to a third party. This would be determined based on how an entity manages its portfolio of debt instruments rather than its intended use of a specific debt instrument. .11 To meet this criterion, an entity's business strategy would need to be to hold instruments within the portfolio for a significant portion of their contractual terms. Companies therefore need to carefully review their debt portfolios to determine whether or not they meet the business strategy criterion. If the business strategy criterion is not met, portfolios of debt instruments currently accounted for as available-for-sale will need to be recorded at fair value through earnings creating additional earnings volatility. Many corporate treasury groups manage portfolios of debt securities representing investments of excess cash. The business

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DataLine 2010-34
strategy of these portfolios is to support the general liquidity needs of the company. As a result, purchases and sales of instruments in the portfolio may occur in shorter time frames than the holding periods currently contemplated in the FASB's requirements for OCI treatment. .12 For debt portfolios that do qualify for the fair value through OCI treatment, companies will need to review their current impairment processes, since the proposal also changes the impairment triggers and the measurement of impairment for debt instruments.

Accounts receivable factoring


.13 Many companies choose to factor their receivables for liquidity or other purposes. Under the proposed guidance, in order for accounts receivable to be recorded at the invoiced amount (as opposed to fair value through earnings), they must meet a number of criteria, one of which is that the business strategy be to hold the accounts receivable for collection of the contractual cash flows. .14 If companies plan to factor their receivables, it may not be possible to assert that the business strategy is to hold them for collection. These receivables may therefore have to be fair valued with changes recorded in earnings. Besides increasing the use of fair value measurement, the proposal will also create operational challenges as many companies may not know at inception which portfolios of receivables will be factored.

Issued convertible debt


.15 Under the proposal, many issued convertible debt instruments will need to be recorded at fair value with changes in fair value recorded in earnings. Convertible debt instruments would generally not be eligible for the fair value through OCI treatment because the convertible debt instrument could be settled in a manner where the investor does not simply receive a stated amount upon settlement (i.e., if the investor chooses to convert, the instrument would be settled through the issuance of shares with an uncertain value). This means earnings volatility driven by movements in interest rates, the entity's share price and the entity's own credit. It will also result in a greater need for valuation expertise and the performance of timely valuations since fair values will need to be reflected in each interim and annual set of financial statements. .16 We believe that under the proposed model, only the liability component of a convertible debt instrument known as "Instrument C" could qualify for either the fair value through OCI treatment or amortized cost. Instrument C is an instrument where the par amount is required to be settled in cash, and only the conversion spread is settled in cash or shares. As a result, companies should review the terms and conditions of their convertible debt issuances.

Embedded derivatives
.17 Under the proposed guidance, hybrid financial instruments with embedded derivatives that are bifurcated under current guidance will be required to be recorded at fair value through earnings in their entirety, regardless of the value of the embedded derivative. No longer will the host contract be recorded separately at the value(s) prescribed by other accounting guidance (e.g., at amortized cost). .18 Currently, some companies may not bifurcate certain hybrid financial instruments containing an embedded derivative if the embedded derivative has only nominal value and is considered immaterial to the financial statements. Because the proposal requires fair value through earning treatment regardless of the value of the embedded derivative, companies will

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DataLine 2010-34
need to carefully review their financial assets and liabilities to determine whether they contain embedded derivatives, even nominal ones. .19 The presence of embedded derivatives in these hybrid financial instruments will result in (1) a greater need for valuation expertise since the entire hybrid instrument (host plus embedded derivative) will now need to be fair valued, (2) a need for timely valuations since the fair values of these instruments will be reflected in each interim and annual set of financial statements, and (3) greater earnings volatility since the changes in fair value of the entire instrument will now be recorded in earnings. .20 This requirement does not affect non-financial contracts (e.g., executory contracts).

Hedge accounting
.21 Under the proposal, the current requirement to quantitatively assess hedge effectiveness each quarter will be replaced with a qualitative assessment at inception and a limited need for reassessment in subsequent periods. Additionally, the proposed model lowers the threshold to qualify for hedge accounting. The hedging relationship now must be "reasonably effective" instead of "highly effective." The proposed model also (1) eliminates the shortcut and critical-terms match methods for assessing hedge effectiveness, (2) prohibits the discretionary de-designation of hedging relationships (unless the derivative exposure is terminated), (3) requires the recognition of the ineffectiveness associated with both over- and under-hedges for all cash flow hedging relationships, and (4) requires the amortization of the cost of a purchased option used as a hedging instrument. .22 In many circumstances, these changes will make it easier to establish and maintain hedging relationships. The proposal may be an opportunity for companies to revisit hedging strategies since some strategies that may not have been highly effective in the past may now meet the "reasonably effective" threshold. However, the requirement to measure and record all ineffectiveness may be more onerous depending on what method of hedge accounting a company is currently employing. Companies currently using shortcut or critical-terms match will need to establish processes to determine the effectiveness of these relationships and record the ineffectiveness of the relationships in earnings.

Next steps
.23 This DataLine was designed to highlight some, but not all, of the potential impacts of the FASB's financial instrument proposal on non-financial services companies. The proposal is complex and will undoubtedly be subject to interpretation upon issuance. For more information on the proposed ASU see DataLine 2010-25. .24 Companies should read the proposed ASU and become familiar with its requirements. Accounting policy and financial reporting groups should begin discussions with the different business units in the organization to assist with an impact analysis. Based upon the results of this analysis, companies should consider commenting on the proposal to the FASB. The comment letter period ends on September 30, 2010.

Questions
.25 PwC clients who have questions about this DataLine should contact their engagement partner. Engagement teams that have questions should contact a member of the Financial Instruments Team in the National Professional Services Group (1-973-236-7803).

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DataLine 2010-34
Authored by:
Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Mark Solak Senior Manager Phone: 1-973-236-4351 Email: mark.w.solak@us.pwc.com

DataLines address current financial-reporting issues and are prepared by the National Professional Services Group of PricewaterhouseCoopers LLP. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2010 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate legal entity. To access additional content on accounting and reporting issues, register for CFOdirect Network (http://www.cfodirect.pwc.com), PricewaterhouseCoopers' online resource for senior financial executives.

US GAAP Convergence & IFRS Revenue recognition

In brief An overview of financial reporting developments


Boards conclude redeliberations on key revenue measurement and recognition issues
What's new?
The FASB and IASB (the boards) reached decisions at their December meeting on allocating the transaction price to separate performance obligations, applying the proposed model to bundled arrangements, constraining the cumulative amount of revenue recognized on licenses, and accounting for contract acquisition costs. The boards decisions are tentative and subject to change. Other key issues still to be redeliberated include scope, disclosures, transition and certain industry specific matters.

No. 2012-58 December 18, 2012

What were the key decisions?


Allocating the transaction price use of the residual approach The boards decided to retain the proposals in the 2011 exposure draft relating to the use of a residual approach to estimate the standalone selling price of a performance obligation. They clarified that this approach can also be used when two or more performance obligations in a contract have standalone selling prices that are highly variable or uncertain. The boards also clarified that when two or more performance obligations have standalone selling prices that are highly variable or uncertain, the transaction price should first be allocated to the performance obligations for which standalone selling prices are determinable. The remaining (residual) transaction price should be allocated between the other performance obligations using another method of estimation. The 2011 exposure draft includes guidance on when discounts and variable consideration in an arrangement should be allocated to specific performance obligations. The boards clarified that discounts or variable consideration should first be allocated to one or more specific performance obligations using that guidance. The entity would then use a residual approach to estimate the standalone selling price of any other performance obligations. Bundled arrangements The boards retained the proposed guidance in the 2011 exposure draft for allocating the transaction price to distinct performance obligations. They confirmed that the proposed guidance can be applied to a portfolio of contracts or to performance obligations with similar characteristics, if the entity expects that doing so would not result in materially

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In brief

different outcomes from applying the guidance to an individual contract or performance obligation. The boards decided not to provide an exception or practical expedient in response to the concerns expressed by the telecommunication industry on the practical challenges of applying the proposed revenue recognition model to a large portfolio of contracts with multiple deliverables. The boards were concerned that doing so would be inconsistent with the objectives of the overall revenue recognition model. Constraining the cumulative amount of revenue recognized licenses The boards decided to remove the specific exception in the 2011 exposure draft that constrained revenue from licenses of intellectual property where payments vary based on the customers subsequent sales (for example, a sales-based royalty). They agreed that when consideration is highly susceptible to factors outside the entity's influence, the entity's experience for determining the transaction price might not be predictive. Highly susceptible factors could include actions of third parties, such as sales by an entity's customers. The boards will enhance the guidance to clarify this point, and that the underlying principle applies to all contracts with customers. Contract acquisition costs The boards decided to retain the guidance in the 2011 exposure draft requiring capitalization of contract acquisition costs if they are incremental and the entity expects to recover the costs. An entity may elect, as a practical expedient, to record these costs as an expense when incurred if the amortization period of the asset is one year or less. The boards considered alternatives, including expensing all contract acquisition costs or allowing a policy choice to expense or recognize contract acquisition costs as an asset. They concluded that the guidance in the 2011 exposure draft is consistent with the decisions reached to date for the leasing, insurance and financial instruments projects, and the practical expedient would minimize implementation issues.

Is convergence achieved?
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both U.S. GAAP and IFRS. Differences might continue to exist to the extent that the guidance requires management to refer to other standards before applying the guidance in the revenue standard.

Who's affected?
The proposal will affect most entities that apply U.S. GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.

Whats the proposed effective date?


We anticipate the final standard to have an effective date no earlier than 2015.

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. They are expected to finalize their redeliberations over the next few months and perform targeted outreach on some of the more significant changes.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377).
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 2

Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Michelle Mulvey Senior Manager Phone: 1-973-236-7272 Email: michelle.l.mulvey@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


Boards make decisions on several major outstanding revenue issues
What's new?
The FASB and IASB (the boards) reached decisions on when revenue from variable consideration should be recognized, presentation of amounts not expected to be collected and licenses at their November meeting on revenue recognition. The boards decisions are tentative and subject to change. Other key issues still to be redeliberated include allocation of transaction price, contract costs, disclosures, and transition.

No. 2012-54 November 20, 2012

What were the key decisions?


Constraint on recognizing revenue from variable consideration The boards agreed to clarify the objective of the constraint on when revenue from variable consideration should be recognized. An entity should recognize revenue as performance obligations are satisfied only up to the amount that the entity is confident will not be subject to significant reversal in the future. An entity should assess its experience with similar types of performance obligations and determine whether, based on that experience, the entity does not expect a significant reversal in future periods in the cumulative amount of revenue recognized. The boards decided to retain the indicators included in the 2011 exposure draft as to when the constraint should apply. The boards decided to apply the constraint to the measurement of the transaction price, as proposed in the 2010 exposure draft. This will constrain the recognition of revenue from variable consideration through the determination of the transaction price rather than creating a separate constraint on the amount recognized subsequent to allocating the transaction price. The boards expect that the amount and timing of revenue recognized should be the same regardless of where the constraint is applied, but asked the staff to consider any unintended consequences of this change. Collectibility The boards agreed that an entity should present any initial and subsequent impairment of customer receivables, to the extent material, as an expense in a separate line item in the statement of comprehensive income. The line should be presented below gross margin, as opposed to a line item adjacent to revenue as proposed in the 2011 exposure draft. The amount cannot be disclosed in the notes to the financial statements rather than being presented on the face of the statement of comprehensive income. This
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In brief

decision would apply to all contracts with customers, whether or not they contain a significant financing component. The boards confirmed the proposals in the 2011 exposure draft that collectibility should not be a threshold for recognition of revenue, as this is not consistent with the controlbased model proposed by the boards. Licenses The boards decided that in some cases a license is a promise to provide a right, which transfers to the customer at a point in time, and in other cases a license is a promise to provide access to an entity's intellectual property, which transfers benefits to the customer over time. Indicators will be provided to help determine the accounting depending on the nature of the license and the commercial substance of the agreement. The boards began with divergent views on whether revenue from the transfer of a license should be recognized at a point in time or over time. The agreed approach outlined above is a compromise by the boards in which they acknowledged there might not be a "one size fits all" approach to accounting for licenses. The boards requested that the indicators provide guidance as to when a license transfers at a point in time or when it provides access. They also commented that the guidance needs to be operational and result in consistent accounting for similar transactions. Board members acknowledged this might be difficult to achieve.

Is convergence achieved?
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both U.S. GAAP and IFRS. Differences might continue to exist to the extent that the guidance requires management to refer to other standards before applying the guidance in the revenue standard.

Who's affected?
The proposal will affect most entities that apply U.S. GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.

Whats the proposed effective date?


We anticipate the final standard to have an effective date no earlier than 2015.

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. They are expected to continue their redeliberations over the next few months and perform targeted outreach on some of the more significant changes.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377).

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In brief

Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Dataline A look at current financial reporting issues


No. 2012-15 October 24, 2012 Whats inside: Overview .......................... 1
At a glance ...............................1 Background .............................1

Revenue from contracts with customers The redeliberations continue


Overview
At a glance

Current developments ....2


Constraining revenue recognition for variable consideration ....................... 2 Collectibility ............................ 5 Time value of money .............. 7 Contract combinations for distributor and reseller arrangements ......... 9 Contract modifications......... 10 Measuring progress toward satisfying a performance obligation ...... 11

The FASB and IASB (the boards) met in September and October 2012 to continue redeliberating their joint revenue recognition project. The boards reached tentative decisions on the constraint for recognizing variable consideration, certain issues related to collectibility, time value of money, distributor and reseller arrangements, contract modifications, and measuring progress toward satisfying a performance obligation. The boards asked their staff to perform additional analysis on the constraint on recognizing revenue from variable consideration and on the presentation of impairment losses on receivables, which will be discussed at a future meeting. Other key issues still to be redeliberated include licenses, allocation of transaction price, disclosures, and transition. The boards currently plan to complete all major redeliberations by the end of 2012. A final standard is planned for the first half of 2013 with an effective date no earlier than January 1, 2015. Full retrospective application, with certain reliefs, will be required unless the boards change their current position. The boards plan to redeliberate transition at a future meeting.

Next steps ....................... 14 Questions ....................... 15 Appendix Redeliberation decisions to date ......... 16

Background .1 The boards issued a revised exposure draft on revenue recognition in November 2011 (the 2011 exposure draft). They decided to re-expose the proposed standard to avoid unintended consequences. Refer to Dataline 2011-35, Revenue from contracts with customers: The proposed revenue standard is re-exposed, for a detailed discussion of the proposed guidance, and Dataline 2012-04, Responses are in on the re-exposed proposed revenue standard, for a discussion of the feedback received in comment letters and roundtables.

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Dataline

.2 The boards made tentative decisions at their July meeting to refine the criteria for identifying separate performance obligations, clarify the criteria for when a performance obligation is satisfied over time, and eliminate the onerous performance obligation assessment from the proposed revenue standard. The boards also discussed the accounting for licenses, but they did not reach any decisions and plan to revisit the topic at a future meeting. Tentative decisions reached at this meeting are discussed in Dataline 2012-07, Revenue from contracts with customers Ready, set, redeliberate. The Appendix to this Dataline summarizes the boards' tentative decisions to date since July and compares them to the 2011 exposure draft. .3 This Dataline summarizes the boards redeliberations and tentative decisions made at the September and October joint meetings and the potential implications for certain industries. These decisions are tentative and subject to change until a final standard is issued.

Current developments
.4 The boards' redeliberations in September and October focused on enhancing and clarifying the proposed guidance in certain areas and suggesting implementation guidance in others. The following topics were discussed:

The constraint on revenue recognition for variable consideration Guidance on collectibility and presentation of impairment losses Accounting for time value of money Accounting for distributor and reseller arrangements Guidance on contract modifications Measuring progress toward satisfying a performance obligation

Constraining revenue recognition for variable consideration .5 The 2011 exposure draft provides guidance on the accounting for consideration that is variable or contingent on the outcome of future events (for example, discounts, incentives, and royalties). An estimate of variable consideration is included in the transaction price and allocated to separate performance obligations. Variable consideration is recognized as revenue when an entity is reasonably assured to be entitled to that amount. Predictive experience with similar performance obligations is needed for an entity to be reasonably assured that it will be entitled to that consideration. .6 Judgment is needed to assess whether an entity has predictive experience about the outcome of a contract. The following indicators might suggest an entity's experience is not sufficiently predictive of the outcome of a contract:

The amount of consideration is highly susceptible to factors outside the influence of the entity The uncertainty about the amount of consideration is not expected to be resolved for a long period of time The entity's experience with similar types of contracts is limited The contract has a large number and broad range of possible consideration amounts

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Dataline

.7 The 2011 exposure draft also includes an exception to this principle for certain transactions. An entity that licenses intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service is not reasonably assured to be entitled to the royalty payment until those future sales occur. .8 Respondents generally support constraining revenue recognition on variable consideration if there is not sufficient evidence to support its recognition. It is unclear to some respondents whether reasonably assured is intended to be a quantitative or a qualitative threshold. Others raised concerns about the level of evidence needed when considering reasonably assured as a threshold. The term reasonably assured is currently used as a quantitative probability threshold under IFRS and U.S. GAAP, but with different meanings, which also caused confusion among respondents. Tentative decisions .9 The boards agreed to clarify the guidance for recognizing revenue on variable consideration. An entity will recognize variable consideration as revenue when it has experience with similar types of performance obligations and this experience is predictive, consistent with the 2011 exposure draft. .10 The boards agreed to clarify when an arrangement contains variable consideration. The revenue recognition constraint applies to contracts with a variable price as well as contracts with a fixed price if it is uncertain whether the entity will be entitled to all of the consideration even after the performance obligation is satisfied (for example, specified performance bonuses that are only paid if certain criteria are met). .11 The boards agreed to remove the term reasonably assured to address the confusion highlighted by constituents. The removal of the term is not expected to affect the constraint on revenue recognition, which will focus on whether the entity has predictive experience to determine the amounts to which it expects to be entitled. .12 The boards discussed potential refinements to the guidance for determining when an entity's experience is predictive. The boards staff proposed three alternatives for discussion, but did not suggest making a decision. The three alternatives were:

2011 exposure draft qualitative assessment: Retain the qualitative assessment in the 2011 exposure draft by retaining the indicators, but reinforce the principle of the constraint. Determinative approach: Eliminate the indicators for when an entity's experience is not predictive and require entities to assess the likely outcome. This assessment would consider whether there are other outcomes that have a reasonable possibility of occurring that could differ significantly from the transaction price and, if so, the entity's experience would not be predictive. Confidence threshold: Eliminate the indicators for when an entity's experience is not predictive and make the determination more prescriptive by specifying a level of confidence (for example, "reasonably confident" for a confidence level of 70% - 80% or "highly confident" for a confidence level of 80% - 90%).

.13 Constituents with construction-type contracts raised significant concerns about certain of these alternatives. They felt that aspects of the proposals fundamentally changed the model in the 2011 exposure draft. .14 Board members generally agreed that refinements were needed in this area, but views differed as to when an entity's experience is predictive. Views expressed include:

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Dataline

Some board members noted that the objective of the constraint is to limit subsequent revisions to the reported revenue. Those board members tended to believe that contingent amounts should only be recognized when the contingency is resolved. Other board members felt the 2011 exposure draft provided guidance that allowed for reasonable judgment to reflect the economics of the arrangement and only minor clarifications to the guidance is needed. A few board members questioned how entities would assess whether their experience is predictive, and whether an entity could look to a portfolio of contracts to assess its experience. A majority of board members did not support including a specific confidence threshold as it would be arbitrary and it could potentially be difficult to determine whether an entity's experience results in a particular confidence threshold being met.

.15 No decisions were reached regarding when a reporting entity's experience is predictive. The boards asked their staff to perform additional outreach and analysis, including developing specific examples for further discussion at a future meeting. The boards' discussions about variable consideration have not included any discussion about the specific guidance on accounting for sales-based royalties in license arrangements. PwC observation: The boards made decisions on some of the minor issues involving variable consideration, but one of the largest issues remains unresolved: When should revenue related to variable consideration be recorded? Developing a clear position on this issue is critical to consistent application of the model given the pervasiveness of variable consideration arrangements. There are diverse constituent views on the recognition of variable consideration as different models exist today. Entities that currently recognize variable consideration before the contingency is resolved, such as those that follow construction contract accounting, support the approach in the 2011 exposure draft as it allows for judgment to reflect experience with similar transactions. Other entities, particularly those that do not recognize contingent amounts today until the contingency is resolved, have concerns about these judgments in light of investor and regulatory scrutiny. We agree that the revenue an entity recognizes should be limited to the amount the entity expects to be entitled to based on its predictive experience. We believe the qualitative assessment and related indicators included in the 2011 exposure draft achieve this objective and allow for an appropriate level of judgment by reporting entities to reflect the economics of their arrangements.

Industry perspectives Aerospace & defense and Engineering & construction .16 The aerospace and defense and engineering and construction industries generally accepted the proposed guidance in the 2011 exposure draft for constraining revenue recognition for variable consideration. These industries apply construction contract accounting today, which allows for recognition of variable consideration in revenue when a reasonably dependable estimate can be made (U.S. GAAP) or it is probable of economic benefit (IFRS). These industries expressed concerns with the staffs' new proposals, which

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Dataline

could result in a significant change from today's accounting and from the proposals in the 2011 exposure draft. .17 Many believe more prescriptive criteria, as opposed to indicators, will delay recognition of revenue compared to today when these contracts have not changed. Often contracts include incentive-type payments that are significant to the overall contract price. There is concern that deferring recognition of these amounts when there is a reasonable basis for estimating and recognizing them will not reflect the economics of the contracts with customers. Many are also concerned about the potential interaction of constraining revenue recognition with the loss recognition guidance that will continue to apply to many contracts in these industries. The staff plans to do additional outreach with these industries to better understand their concerns before bringing the topic back for discussion at a future meeting. Collectibility .18 The 2011 exposure draft proposes that an entity present any allowance for receivable impairment losses in a separate line item adjacent to revenue. Both the initial expected impairment and any subsequent changes to that estimate are recorded in this line. The 2011 exposure draft distinguishes between contracts that have a significant financing component and those that do not as follows:

Contracts without a significant financing component: Initial and subsequent impairment of a trade receivable are determined in accordance with ASC 310 or IFRS 9 / IAS 39 and presented in a separate line item adjacent to revenue. Contracts with a significant financing component: The transaction is bifurcated into a revenue component and a loan component. The revenue component is in the scope of the revenue guidance; the loan component is in the scope of the financial instruments standards. Consequently, the impairment of receivables from contracts with a significant financing component will likely be presented differently from those contracts without a significant financing component, and will not be presented adjacent to revenue.

.19 Respondents generally disagree with presenting the effects of credit risk adjacent to revenue and recommend that entities continue to record losses from receivable impairments as an operating expense that does not affect gross profit. Other feedback focuses on whether the effects of credit risk need to be presented on the face of the income statement or whether disclosure would be sufficient. A few respondents raised concerns about collectibility no longer being a hurdle to recognizing revenue, and feel such a threshold should be brought back into the proposed guidance. Tentative decisions .20 The boards confirmed that initial and subsequent impairments of receivables should be presented in the same financial statement line item. The boards did not conclude on where the impairment loss should be presented in the income statement, as they struggled to decide whether presentation should be different when there is a significant financing component in a contract. The discussion focused on the following three options:

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Dataline

Income statement presentation options Present all impairment losses in operating expenses (similar to presentation under current standards) Present all impairment losses arising from contracts without a significant financing component adjacent to revenue and all impairment losses arising from contracts with a significant financing component in operating or other expenses Present all impairment losses adjacent to revenue

Concerns raised by board members Presenting revenue at the amount which the entity will be entitled could be misleading if an entity does not expect to collect certain amounts and the presentation of those uncollectible amounts is disconnected from the related revenue. This approach might impact comparability, as the presentation of uncollectible amounts related to sales will differ based on the payment terms.

Impairment losses related to transactions for goods or services with significant financing components will be presented differently from impairments of a loan even when the underlying financial instrument is economically the same.

.21 The boards asked their staff to perform further analysis on these alternatives, including what disclosures might be required for each. .22 The debate over presentation of impairment losses reintroduced the question of whether collectibility should be a threshold for recognizing revenue. Some board members suggested the staff consider whether a collectibility threshold might be employed with a principle consistent with that for recognizing revenue from variable consideration. The boards requested their staff evaluate the potential consequences of such a threshold, and whether a threshold would be consistent with the core principles in the model. Further discussion is planned for a future meeting. .23 The boards also considered when revenue should be recognized for contracts that involve financing provided by the seller where the borrower can put the collateral back to the seller in satisfaction of the loan (non-recourse seller financing). They will provide additional implementation guidance about whether a contract with a customer exists based on when the parties are committed to perform their obligations under the contract. They will also clarify the scope of the proposed revenue guidance in this area. Parties might not be committed to perform under the contract if payment terms reflect uncertainty about the customer's intent on following through with its obligations. PwC observation: Presenting impairment losses adjacent to revenue will align revenue recognized with cash ultimately received from the customer if the contract does not have a significant financing component. This presentation will help financial statement users who are interested in reconciling revenue with cash received.

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A collectibility threshold could contradict the control-based revenue recognition model proposed by the boards by delaying revenue recognition until after control of the promised goods or services transfers to the customer. Few respondents raised concerns about collectibility being a hurdle to revenue recognition, with most preparers being in favor of the proposed change from current guidance.

Industry perspectives Real estate .24 Respondents in the real estate industry expressed concern about what they perceive as "inappropriate acceleration" of revenue under the proposed model, particularly for entities following U.S. GAAP who enter into contracts with customers that contain nonrecourse, seller-based financing. Those respondents believe that the collectibility requirements in today's accounting are the best indicators of an entity's commitment to a contract and therefore, the appropriateness of revenue recognition for those transactions. .25 The clarification of when the parties in a contract are committed to perform their respective obligations will help real estate entities assess when a contract exists before applying the rest of the proposed revenue recognition model. Time value of money .26 The 2011 exposure draft proposes that the transaction price should reflect the time value of money when the contract contains a significant financing component. Management should consider the following factors, among others, to determine if there is a significant financing component in a contract:

The length of time between when the entity transfers the goods or services to the customer and when the customer pays for them Whether the amount of consideration would substantially differ if the customer paid cash when the goods or services were transferred The interest rate in the contract and prevailing interest rates in the relevant market

.27 The 2011 exposure draft also includes a practical expedient that allows entities to ignore the time value of money if the time from transfer of the goods or services to payment is less than one year. .28 Many respondents acknowledge the theoretical basis for accounting for the effects of the time value of money but have concerns that the proposal is too broad and would require an adjustment for financing on too many transactions. The majority of respondents argue that the cost of reflecting the time value of money outweighs the benefit to users; they recommend that the boards remove this requirement. Some also suggest removing the practical expedient as it is arbitrary and does not provide adequate relief. Tentative decisions .29 The boards affirmed their decision to require adjustment to the transaction price for the effects of the time value of money when a significant financing component exists in a contract. .30 The staff recommended that the boards narrow the application of the proposals by only requiring entities to adjust for financing on transactions when the primary purpose of the payment terms is to provide financing to either the customer or the entity. The
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staff believes this will ease concerns that the guidance is too broad. The boards rejected this recommendation and requested that the staff prepare examples to illustrate when an arrangement includes a significant financing component. .31 The boards clarified that an entity that is paid in advance for goods or services need not reflect the effects of the time value of money when the timing of transfer of those goods or services to the customer is at the customer's discretion. An example of such an arrangement is where a customer purchases a prepaid phone card from a telecom entity and uses the prepaid airtime at his or her discretion. Another example is a customer loyalty program where the customer can redeem the points awarded by the entity at his or her discretion. Those entities will not be required to account for time value of money even though there could be a significant timing difference between payment and performance. .32 The boards retained the practical expedient and clarified that it also applies to contracts where the contract term is greater than one year but the timing difference between payment and performance is one year or less. .33 The boards also clarified that the proposals require interest income to be presented separately from revenue from the sale of goods or services, but do not preclude interest income from being presented as a type of revenue. The proposed guidance suggests that an entity will not be precluded from presenting interest income as revenue if it generates interest income in the ordinary course of business similar to a financial services entity. PwC observation: It might be difficult to determine whether a significant financing component exists in a contract, particularly in long-term or multiple-element arrangements where goods or services are delivered, and cash payments received throughout the arrangement. Management will need to assess the timing of delivery of goods and services in relation to cash payments to determine if there is a gap in excess of one year, which could indicate that a significant financing component exists. This could include transactions where payment is received in advance and services are provided over time. The FASB acknowledged respondents' concerns about the breadth of application. The IASB reiterated that accounting for the time value of money has been a component of various IFRS standards (including IAS 18, Revenue) for years and the proposed guidance should not introduce a significant change for entities applying IFRS, despite constituent concerns. It remains to be seen if the boards will agree on the examples being developed by the staff in this area. The diverse perspectives of board members could affect what they view as a "significant financing component," especially given the differing application of time value of money under current U.S. GAAP and IFRS.

Industry perspectives Entertainment and media .34 Many entities in the entertainment and media industry could be affected by the proposed time value of money guidance. An entity that licenses an episodic television series to a broadcaster where the content is delivered upfront, but payments are received over a contract term greater than one year, might need to account for the effects of the time value of money.

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Telecommunications .35 Those in the telecom industry could be affected by the proposed time value of money guidance in some situations. An entity that sells a handset for a reduced price to secure the customer's obligation to purchase phone service for a set period of time might need to consider the effects of the time value of money. Assuming the amount allocated to the handset is paid throughout the service period, a timing difference arises between the transfer of control of the handset and the payment. The financing component might be difficult to determine in these situations. Financial services .36 Entities in the financial services industry generate interest income in the ordinary course of business. The 2011 exposure draft's requirement to present the interest component of a significant financing separately from revenue concerned entities in this industry, particularly with respect to whether interest income could be presented as revenue. The boards' clarification that the proposal does not preclude presenting interest income as revenue alleviates these concerns. Contract combinations for distributor and reseller arrangements .37 The 2011 exposure draft proposes to combine contracts and account for them as a single contract only if they are entered into at or near the same time and with the same customer (or related parties), and one or more of the following criteria are 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 The goods or services promised in the separate contracts are a single performance obligation

.38 A few respondents have concerns because, in many instances, they offer a good or service to an end customer, but do not directly provide or perform the promised good or service themselves. They asked for clarification of how the boards intend the requirements to be applied in these situations. .39 The boards previously considered whether entities should account for goods or services provided as sales incentives differently from the primary goods or services in a contract; the boards concluded entities should not. Some respondents believe they should account for these incentives differently from the primary goods or services in a contract. .40 Cash consideration paid to a customer or other parties that purchase an entity's goods or services from the customer are accounted for as a reduction in the transaction price under the 2011 exposure draft, unless it was paid for a distinct good or service. Promises to provide goods or services, on the other hand, are accounted for as additional performance obligations. Some respondents believe that promises to provide goods or services to a customer should be accounted for the same as promises to pay cash to the customer when the entity does not directly provide those goods or services. Tentative decisions .41 The boards clarified that all promises in a contract, whether explicit or implicit, to provide goods or services, including offers to provide goods or services that the customer can resell or provide to its customer, are performance obligations, even if they are satisfied by another party. The boards noted that these promises are different from promises to pay cash to the customer. Promises to pay cash to a customer are not
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performance obligations and are accounted for as reductions of the transaction price, unless paid for a distinct good or service. .42 The boards also concluded that the accounting for promises in a contract made at contract inception might differ from the accounting for promises made subsequently if those promises were not anticipated at contract inception. Contract modification guidance should be applied to promises made after contract inception. PwC observation: The boards' clarification to the proposed standard did not change the substance of the 2011 exposure draft. Entities that provide an offer of goods or services to an end customer that will be honored by a third party will need to allocate some of the transaction price to those goods or services and recognize revenue as those goods or services are delivered or performed. Some entities offering these incentives might find the proposed model more complex than current practice.

Industry perspectives Automotive .43 Automotive manufacturers often provide offers such as free maintenance to customers who purchase their vehicles from a branded dealership. Some in the industry believe that an offer of free maintenance is no different from an offer of a cash refund. They believe, therefore, that the accounting should be the same as the accounting for a cash incentive, particularly when the manufacturer does not provide the free services to the end customer. The boards' clarification confirms that these offers are promised services. Manufacturers that offer incentives such as free maintenance through dealership networks will need to account for the offer as a separate performance obligation even though the manufacturer will not perform the maintenance service. Contract modifications .44 A contract modification is treated as a separate contract under the 2011 exposure draft if it results in the addition of a separate performance obligation and the price reflects the stand-alone selling price of that obligation. A modification is otherwise accounted for as an adjustment to the original contract, either prospectively or through a cumulative catch-up adjustment, depending on the facts and circumstances. .45 Respondents expressed concerns about the complexity of the proposed guidance, but generally did not disagree with the conceptual basis of the guidance. Questions were raised about the accounting for changes to scope or price that are not approved or are in dispute. Some believe application guidance would be helpful for situations where the parties to a contract approve a change in scope, but have not agreed on the price (commonly referred to as "unpriced change orders"), and for the accounting for disputes (contract claims). Tentative decisions .46 The boards considered providing additional guidance for modifications from "contract claims" (for example, when an entity seeks additional consideration for customer-caused delays, changes, and errors in specifications and designs). They decided to retain the guidance proposed in the 2011 exposure draft for contract modifications, as they believe it adequately addresses these situations. They will clarify that a contract modification, including a contract claim, is approved when the modification creates or changes the enforceable rights and obligations of the parties to the contract, which could

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be in writing, orally, or implied by customary business practice. The boards will consider including an example that illustrates a modification due to contract claims. .47 The boards also clarified that the accounting for a contract modification that only affects the transaction price should be treated like any other contract modification. The change in price will be either accounted for prospectively or on a cumulative catch-up basis, depending on whether the remaining performance obligations are distinct. PwC observation: The boards' decisions do not change the substance of the guidance in the 2011 exposure draft, but provide clarifications in an area where constituents found the guidance difficult to follow. These clarifications should help entities better understand the proposed guidance; however, determining whether a modification should be accounted for prospectively or as a cumulative catch-up adjustment will still be judgmental.

Industry perspectives Aerospace & defense and Engineering & construction .48 Contract modifications in the aerospace and defense and the engineering and construction industries often include changes to scope or price that might be unapproved or in dispute. These modifications are often agreed to after the contractor provides the related service. Respondents believe the proposed accounting for these modifications is unclear and recommend carrying forward existing guidance. Existing guidance is similar under IFRS and U.S. GAAP and allows for recognition of amounts subject to claims or unapproved change orders in certain circumstances. .49 The boards' decisions in this area are not likely to mitigate the concerns of entities in these industries. Management will need to assess the modification guidance and determine if a modification, such as a claim or unpriced change order, is approved either in writing, orally, or though customary business practice before recognizing the related revenue. Measuring progress toward satisfying a performance obligation customized manufacturing and output methods .50 The 2011 exposure draft states that for a performance obligation satisfied over time, the objective is to depict the transfer of control of the promised goods or services to the customer. Methods for measuring progress include:

Output methods that recognize revenue based on units produced or delivered, contract milestones, or surveys of work performed Input methods that recognize revenue based on costs incurred, labor hours expended, time lapsed, or machine hours used

.51 Some respondents requested that the boards clarify whether "units delivered" can be used to measure progress in manufacturing contracts satisfied over time or in contracts where a vendor manufactures large volumes of homogeneous goods but also meets the requirements for performance obligations satisfied over time. These respondents also requested further guidance on accounting for the related costs of production when this measure is used.

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Tentative decisions .52 The staff proposed a practical expedient to allow the use of a units delivered measure when a vendor manufactures large volumes of homogeneous goods but also meets the requirements for performance obligations satisfied over time. The boards rejected this proposal because they felt it circumvents the guidance on when performance obligations are satisfied over time. Manufacturers of large volumes of homogeneous goods that meet the requirements for performance obligations satisfied over time will therefore need to assess what measure of progress depicts the transfer of goods or services to the customer. Transfer might not be upon delivery of the product in some situations. PwC observation: Entities that manufacture large volumes of homogeneous goods to a customer's specification (for example, contract manufacturers) might be surprised to find that they could meet the criteria for performance obligations satisfied over time. This is due the fact that (1) such goods often have no alternative use to the entity given their customization and (2) the payment terms in these arrangements might include a protective clause that provides for payment for performance to date in the event the contract is cancelled. The boards' decision not to include a practical expedient for these situations could have broad consequences. Entities that manufacture these types of goods could be required to recognize revenue as the goods are produced, rather than when they are delivered to the customer. Different outcomes for economically similar arrangements could result from this proposed guidance. Slight differences in payment terms could result in the goods being treated as a performance obligation satisfied over time in one case and as inventory in another. Take as an example Entity A, which manufactures customized goods with no alternative use. The customized goods have a short manufacturing cycle so any work in process at the end of a period is likely to be immaterial. Entity A's contract terms require its customers to pay cost plus a profit on all finished goods and any work in process if the contract is cancelled. The goods being produced meet the criteria for performance obligations satisfied over time with revenue recognized as control is transferred, which is likely to be as the goods are produced. Compare that situation to Entity B, which also manufactures customized goods with no alternative use. Entity B has structured its contract terms so that its customers will pay cost plus a profit on all finished goods, but Entity B will only be reimbursed for out-of-pocket costs for work in process if the contract is cancelled. The profit on work in process would be immaterial to both Entity B and its customer. The goods being produced do not meet the criteria for performance obligations satisfied over time, resulting in revenue being recognized when control transfers to the customer, which might be on delivery. The proposed definition of when an asset has no alternative use, coupled with right to payment for performance completed to date, might lead to unintended consequences. This is because the proposed definition considers customer protective rights (such as contractual terms that preclude transfer to another customer) as a determining factor of when an asset has no alternative use. The definition is inconsistent with recognizing revenue when control transfers because customer protective rights do not determine control.

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Measuring progress toward satisfying a performance obligation uninstalled materials and input methods .53 The 2011 exposure draft also proposes guidance for situations where an input method is used to measure progress and there are uninstalled materials that a customer controls prior to the performance of the services related to those goods. Revenue should be recognized only to the extent of the cost for those materials if:

the cost of the goods is significant relative to the expected costs to satisfy the performance obligation, and the entity procures the goods from another entity and is not significantly involved in designing and manufacturing the goods.

.54 Respondents generally disagree with the proposed guidance for uninstalled materials, as recognizing a zero profit margin for uninstalled materials might not reflect the economic substance of a contract in many situations. The concern is that different accounting could result if the entity constructs a large component rather than subcontracting the construction of that component. Profit could be recognized on the self-constructed component, but not on the subcontracted one. Tentative decisions .55 The boards also agreed to clarify the guidance for uninstalled materials. The feedback received indicates that this guidance is being interpreted more broadly than the boards intended. The clarifications should more closely align the guidance with the objective of measuring progress by only including in the measure of progress goods or services that depict transfer to the customer. This might result in revenue equal to the cost of the goods being recognized in some situations, but not in others. The boards also agreed to amend the example included in the implementation guidance to be consistent with this clarification. Industry perspectives Aerospace and defense .56 Most respondents agree with the proposals for measuring progress, but request the boards clarify when a units delivered measure is appropriate. They also question the timing of cost recognition when such a method is used to measure progress. Many are concerned that contract costs will be expensed as incurred as fulfillment costs, which could be in advance of revenue recognition when progress is measured based on units delivered or produced. This is a change from today's contract accounting guidance. Many respondents feel it will distort the margin during contract performance and does not therefore reflect the economics of a contract satisfied over time. These respondents recommend that entities be allowed to use a systematic and rational approach for recognizing contract costs to reflect the single overall profit margin of the arrangement. .57 The boards' decisions did not address these concerns as the guidance in the exposure draft was retained. Entities will need to assess contracts where performance obligations are satisfied over time and select a measure of progress that depicts the transfer of goods and services to the customer. Engineering and construction .58 Common in many engineering and construction contracts is the use of third parties, such as sub-contractors, to construct goods specifically for a project. These goods could remain uninstalled for a significant period of time due to long lead times to engineer, fabricate, and construct these items, or other factors. The proposed standard requires

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that an entity only recognize revenue to the extent of the cost of such uninstalled materials. .59 Respondents generally believe profit should be recognized on goods specifically produced for a project consistent with the overall contract profit margin, as contracts are typically bid and negotiated with an overall profit objective. Transfer of materials customized specifically for a project represents progress toward satisfying the performance obligation and should therefore include the recognition of profit on that progress. .60 The boards decision to clarify the guidance for uninstalled materials should help address some of the concerns of entities in this industry. Aligning this guidance with the objective of measuring progress toward satisfying a performance obligation should help avoid uneconomic outcomes. Consumer industrial products and other contract manufacturers .61 Many respondents that manufacture customized products for specific customers are concerned with possible unintended consequences of the guidance on performance obligations satisfied over time. Many contracts for these customized products could meet the criteria for recognition over time because the goods being produced have no alternative use and have contract terms providing for a right to payment for work performed in the event of a cancellation. .62 Entities with contracts that meet the requirements for performance obligations satisfied over time as a result of how "alternative use" is defined will need to select a measure of progress that depicts the transfer of control of the goods or services to the customer, which might not be upon delivery of the product. .63 The pattern of revenue recognition in these cases could shift from recognition upon delivery under today's guidance to recognition as the goods are produced. Contract manufacturers believe they are manufacturing inventory items for a customer and that the customer also views the transaction as the purchase of inventory. They believe the accounting model should reflect this shared understanding. .64 Respondents also disagree with the guidance on uninstalled materials when an entity uses subcontractors that provide as is equipment for installation into a final product or service. The proposed standard requires the revenue recognized for this performance obligation to equal the cost of the equipment acquired from a subcontractor (that is, a zero percent profit margin). Respondents disagree with allocating a zero percent profit margin for goods purchased from a subcontractor contending that the entity is providing the customer a turn-key solution, not just passing through the equipment. .65 The boards' decision to clarify the guidance on uninstalled materials to better align this guidance with the objective of measuring progress toward satisfying a performance obligation should help address the concerns raised by respondents.

Next steps
.66 The boards' redeliberation plan includes several key issues still to be discussed. These include additional discussions about licenses, the constraint on recognition of revenue from variable consideration, and collectibility, as well as discussions about disclosures and transition. .67 A final standard is planned for the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted outreach on some of the more significant changes.

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Questions
.68 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377 or 1-973-236-7804).

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Appendix Redeliberation decisions to date


The table below summarizes the decisions reached by the boards to date. These decisions are tentative and subject to change until a final standard is issued.

Topic
Identifying the contract

November 2011 Exposure Draft


A contract exists if all of the following criteria are met: The contract has commercial substance The parties to the contract have approved the contract and are committed to perform their respective obligations Management can identify each party's rights and obligations regarding the goods or services to be transferred Management can identify the terms and manner of payment for the goods or services to be transferred

Tentative Decision
The boards decided to include indicators of when parties to the contract are committed to perform their respective obligations. Some of the indicators being considered are: Whether payment terms reflect uncertainty about the customer's intent The reasons for entering into the contract in light of the parties' business models Experience or lack of thereof with the customer for similar transactions

Contract combinations for distributor and reseller arrangements

An entity may need to combine two or more contracts entered into at or near the same time with the same customer if one or more of the following criteria are 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 The goods or services promised in the separate contracts are a single performance obligation

The boards clarified that all promises to provide goods or services, including offers to provide goods or services that the customer can resell or provide to its customer, are performance obligations even if they are satisfied by another party. These promises are different from promises to pay cash to the customer, which are accounted for as reductions of the transaction price, unless paid for a distinct good or service.

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Topic
Contract modifications

November 2011 Exposure Draft


A contract modification is treated as a separate contract only if it results in the addition of a distinct performance obligation and the price is reflective of the stand-alone selling price of that additional performance obligation. The modification is otherwise accounted for as an adjustment to the original contract, either through a cumulative catch-up adjustment to revenue or a prospective adjustment to revenue when future performance obligations are satisfied, depending on the facts and circumstances.

Tentative Decision
The boards decided to retain the guidance proposed in the 2011 exposure draft for contract modifications. The boards also decided to clarify that a contract modification, including a contract claim, is approved when the modification creates or changes the enforceable rights and obligations of the parties to the contract, which could be in writing, orally or implied by customary business practice. The boards will also consider including an example that addresses modifications due to contract claims and/or unpriced change orders. The boards also clarified that the accounting for a contract modification that only affects the transaction price should be treated like any other contract modification. The change in price will be accounted for either prospectively or on a cumulative catch up basis, depending on whether the remaining performance obligations are distinct.

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Topic
Identifying separate performance obligations

November 2011 Exposure Draft


A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with resources readily available to the customer

Tentative Decision
The boards decided that an entity should account for a promised good or service (or a bundle of goods or services) as a separate performance obligation only if both of the following criteria are met: The promised good or service is capable of being distinct because 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 The promised good or service is distinct within the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract

A bundle of goods or services is accounted for together as one performance obligation if both of the following criteria are met: The goods and services are highly interrelated and the entity provides a significant service of integrating goods and services into the combined item that the customer has contracted for The entity is contracted by the customer to significantly modify or customize the goods or services

The boards agreed that the assessment of whether a promised good or service is distinct in the context of the contract should be supported by indicators, such as: The entity does not provide a significant service of integrating the goods or services The customer was able to purchase or not purchase the good or service without significantly affecting the other promised goods or services in the contract The good or service does not significantly modify or customize another good or service promised in the contract The good or service is not part of a series of consecutively delivered goods or services promised in a contract that meets the following two conditions: 1. The promises to transfer those goods or services to the customer are performance obligations that are satisfied over time The entity uses the same method for measuring progress to depict the transfer of those goods or services to the customer

2.

The boards decided to remove the practical expedient that permitted an entity to account for two or more distinct goods or services as a single performance obligation if those goods or services have the same pattern of transfer to the customer.

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Topic
Collectibility

November 2011 Exposure Draft


Collectibility of the transaction price is not a hurdle to revenue recognition. The transaction price is presented without adjustment for credit risk. An allowance for the expected impairment loss on receivables is presented in a separate line item adjacent to revenue. Both the initial impairment assessment and any subsequent changes in the estimate of collectibility are recorded in this line (if the contract does not have a significant financing component).

Tentative Decision
The boards confirmed that initial and subsequent impairments of receivables should be presented in the same financial statement line item. They did not conclude, however, on where the impairment should be presented in the income statement. This debate raised once again the question of whether collectibility should be a threshold for recognizing revenue. The boards asked the staff to perform further analysis including evaluating the potential consequences of a collectibility threshold. Further discussion is planned for a future meeting. The boards clarified that an entity paid in advance for goods or services need not reflect the effects of time value of money when the transfer of those goods or services to the customer is at the discretion of the customer. The boards clarified that the practical expedient may be applied to contracts where the term may be greater than one year, but the timing difference between payment and performance is one year or less. The boards clarified that interest income is not precluded from being presented as a component of revenue.

Time value of money

The transaction price should reflect the time value of money when the contract includes a significant financing component. As a practical expedient, an entity is not required to reflect the effects of the time value of money in the measurement of the transaction price when the period between payment by the customer and the transfer of the goods or services is less than one year.

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Topic
Performance obligations satisfied over time

November 2011 Exposure Draft


A performance obligation is satisfied over time if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity and one of the following criteria is met: The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially reperform the task(s) if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fulfill the contract

Tentative Decision
The boards decided to make the following refinements to the criteria for determining whether an entity satisfies a performance obligation over time and, hence, recognizes revenue over time: Retain the criterion that considers whether the entitys performance creates or enhances an asset that the customer controls as the asset is created or enhanced Combine the simultaneous receipt and consumption of benefits criterion and the another entity would not need to substantially reperform proposed criterion into a single criterion that would apply to pure service contracts Link more closely the alternative use criterion and the right to payment for performance completed to date criterion by combining them into a single criterion

The boards also decided to clarify aspects of the alternative use and right to payment for performance completed to date criteria. For example: The assessment of alternative use is made at contract inception and that assessment considers whether the entity would have the ability throughout the production process to readily redirect the partially completed asset to another customer. The right to payment should be enforceable and, in assessing the enforceability of that right, an entity should consider the contractual terms as well as any legislation or legal precedent that could override those contractual terms.

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Topic
Measuring progress toward satisfying a performance obligation

November 2011 Exposure Draft


The objective is to faithfully depict the pattern of transfer of the goods or services to the customer. Methods for recognizing revenue when control transfers continuously include: Output methods that recognize revenue on the basis of the value of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved) Input methods that recognize revenue on the basis of inputs to the satisfaction of a performance obligation (for example, time lapsed, resources consumed, labor hours expended, costs incurred, and machine hours used)

Tentative Decision
The boards agreed to retain the guidance from the exposure draft for measuring progress toward satisfying a performance obligation over time. The boards tentatively decided that methods such as "units produced" or "units delivered" could provide a reasonable proxy for the entitys performance in satisfying a performance obligation in the following circumstances: A "units produced" method could provide a reasonable proxy for the entitys performance if the value of any work in progress at the end of the reporting period is immaterial A "units delivered" method could provide a reasonable proxy for the entitys performance if: 1. the value of any work in progress at the end of the reporting period is immaterial; and the value of any units produced but not yet delivered to the customer at the end of the reporting period is immaterial.

An entity may select an appropriate input method if an output method is not directly observable or available to an entity without undue cost. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if the costs of goods are significant and transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Constraint on revenue recognition Revenue is recognized when the performance obligation is satisfied and the entity is reasonably assured to be entitled to the transaction price allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration if both of the following criteria are met: The entity has experience with similar types of performance obligations The entity's experience is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations

2.

They also agreed to clarify the accounting for uninstalled materials, wasted materials, and inefficiencies when using an input method to better meet the objective of measuring progress to depict the pattern of transfer of goods or services to the customer.

The boards agreed to clarify that this constraint applies to contracts with a variable price and to contracts with a fixed price where it is uncertain whether the entity will be entitled to that consideration even after the performance obligation is satisfied. The boards also agreed to remove the term reasonably assured to avoid confusion as that term has different meanings under current IFRS and U.S. GAAP guidance. The boards discussed enhancements to the guidance for determining when an entitys experience is predictive of the amount of variable consideration to which it will be entitled. Further discussions are expected at a future meeting after the boards perform additional outreach.

For licenses to use intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service, the related variable consideration only becomes reasonably assured once those future sales occur.

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Topic
Licenses and rights to use

November 2011 Exposure Draft


The promised rights are a performance obligation that the entity satisfies when the customer obtains control (that is, the use and benefit) of those rights. An entity should consider whether the rights give rise to a separate performance obligation or whether the rights should be combined with other performance obligations in the contract.

Tentative Decision
The boards discussed possible refinements to the implementation guidance on accounting for licenses. They directed the staff to perform additional analysis and bring the topic back to a future meeting.

Onerous performance obligations

An entity should recognize a liability and corresponding expense if a performance obligation that is satisfied over a period of time is onerous. The performance obligation will not need to be assessed if it is satisfied over a period less than one year. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of transaction price allocated. The lowest cost of settling a performance obligation is the lower of the following: The costs directly related to satisfying the performance obligation The amount the entity would have to pay to exit the performance obligation

The boards decided to remove this guidance from the scope of the revenue standard. As a result, the IASB decided that the requirements for onerous contracts in IAS 37, Provisions, Contingent Liabilities and Contingent Assets, should apply to all contracts with customers in the scope of the revenue standard. The FASB decided to retain existing guidance related to the recognition of losses arising from contracts with customers, including the guidance relating to construction-type and productiontype contracts in Subtopic 605-35, Revenue RecognitionConstruction-Type and Production-Type Contracts. The FASB also indicated it would consider whether to undertake a separate project to develop new guidance for onerous contracts.

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Dataline 22

Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Larry Westall Partner Phone: 1-408-817-4284 Email: larry.westall@us.pwc.com Brian Wiegmann Director Phone: 1-973-236-7054 Email: brian.c.wiegmann@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com Michelle Mulvey Senior Manager Phone: 1-973-236-7272 Email: michelle.l.mulvey@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB and IASB decide on revenue contract modifications and measures of progress
What's new?
The FASB and IASB (the boards) met on October 18, 2012 to discuss their joint project on revenue recognition. They reached decisions on contract modifications and measures of progress towards satisfying a performance obligation. The boards decisions are tentative and subject to change. Other key issues still to be redeliberated include collectibility, the constraint on recognizing revenue from variable consideration, licenses, allocation of transaction price, disclosures, and transition.

No. 2012-46 October 19, 2012

What were the key decisions?


Contract modifications Revenue from contract modifications that have not been approved by the parties to the contract should not be recognized until the modification is approved. The boards considered providing additional guidance for modifications resulting from "contract claims." For example, an entity might seek additional consideration for customer-caused delays, changes, errors in specifications and designs, etc. The boards decided to retain the guidance proposed in the 2011 exposure draft for contract modifications, as they believe it adequately addresses these situations. They agreed, however, to consider including an example that addresses modifications due to contract claims. The boards also clarified that the accounting for a contract modification that only affects the transaction price should be assessed like any other contract modification. The change in price will then be either accounted for prospectively or on a cumulative catch-up basis depending on whether the remaining performance obligations are distinct. Measures of progress towards satisfaction of a performance obligation Revenue is recognized for a performance obligation satisfied over time as the entity progresses toward satisfying that performance obligation. Appropriate methods to measure progress include output methods, such as units produced, and input methods, such as costs incurred. The boards considered whether a practical expedient should be introduced to address situations where a vendor manufactures large volumes of homogeneous goods that also meet the requirements to be accounted for as performance obligations satisfied over time. The boards made no changes to the proposed guidance. They confirmed that an entity should select a method that depicts the transfer of control of the goods and services to the customer, which might be during production rather than
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

upon delivery of the product. This could result in a change in the timing of revenue recognition from today for some entities. The boards agreed to clarify the guidance for situations where an input method is used, and a customer obtains control of goods significantly in advance of when the entity performs the services related to those goods (that is, uninstalled materials). Feedback received by the boards suggests that this guidance is being interpreted more broadly than they intended. The proposed clarifications should more closely align this guidance with the objective of measuring progress by only including in the measure of progress goods or services that depict transfer to the customer. In certain situations, revenue equal to the cost of the goods should be recognized.

Is convergence achieved?
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both U.S. GAAP and IFRS. Differences might continue to exist to the extent that the guidance requires management to refer to other standards before applying the guidance in the revenue standard.

Who's affected?
The proposal will affect most entities that apply U.S. GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.

Whats the proposed effective date?


We anticipate the final standard to have an effective date no earlier than 2015.

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. They are expected to continue their redeliberations over the next few months and perform targeted outreach on some of the more significant changes.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Michelle Mulvey Senior Manager Phone: 1-973-236-7272 Email: michelle.l.mulvey@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB and IASB make progress on revenue redeliberations; more to come
What's new?
The FASB and IASB (the boards) met on September 24 and 27 to discuss their joint project on revenue recognition. They reached decisions on certain topics relating to the constraint on recognizing variable consideration, collectibility, time value of money, and distributor and reseller arrangements. The boards decisions are tentative and subject to change. The boards directed their staff to conduct further analysis on certain items, including aspects of the variable consideration constraint and presentation issues relating to collectibility. Other key issues still to be redeliberated include licenses, contract modifications, allocation of transaction price, disclosures, and transition.

No. 2012-44 September 28, 2012

What were the key decisions?


Constraint on recognizing variable consideration The proposed model requires variable consideration that is recognized as revenue to be constrained to the amount to which the entity is reasonably assured to be entitled. The boards agreed to clarify that this constraint applies to contracts with a variable price and to contracts with a fixed price where it is uncertain whether the entity will be entitled to that consideration even after the performance obligation is satisfied. The boards also agreed to remove the term reasonably assured to avoid confusion as that term has different meanings under current IFRS and U.S. GAAP guidance. The boards discussed enhancements to the guidance for determining when an entity s experience is predictive of the amount of variable consideration to which it will be entitled. Further discussions are expected at a future meeting after the boards perform additional outreach. Collectibility The boards confirmed that initial and subsequent impairments of receivables should be presented in the same financial statement line item. They did not conclude, however, on where the impairment should be presented in the income statement. This debate also raised once again the question of whether collectibility should be a threshold for recognizing revenue. The boards asked their staff to perform further analysis including evaluating the potential consequences of a collectibility threshold, and whether it would be consistent with the core principles of the proposed model. Further discussion is planned for a future meeting.
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 1

The boards also considered when revenue should be recognized for contracts with nonrecourse, seller-based financing. They agreed to provide additional implementation guidance about whether a contract with a customer exists based on when the parties may or may not be committed to perform their obligations under the contract. Time value of money The boards agreed to retain the proposed guidance that requires adjustment to the transaction price for the effect of time value of money if the contract has a significant financing component. They will, however, consider providing additional implementation guidance for inclusion in the final standard at a future meeting. They also decided to retain the practical expedient that does not require an adjustment for time value of money if the time difference between performance and payment is one year or less. The boards clarified that an entity does not need to reflect the effect of time value of money for advance payments when the timing of the transfer of goods or services is at the discretion of the customer. Contract combinations for distributor and reseller arrangements The boards clarified that promised goods or services in a contract might include offers to provide goods or services that the customer can resell or provide to its customer. They confirmed that these promises are performance obligations even if they are satisfied by another party, and are different from promises to pay cash to the customer, which are accounted for as a reduction of the transaction price.

Is convergence achieved?
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both U.S. GAAP and IFRS. Differences might continue to exist to the extent that the guidance requires reference to other standards before applying the guidance in the revenue standard.

Who's affected?
The proposal will affect most entities that apply U.S. GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.

Whats the proposed effective date?


We anticipate the final standard to have an effective date no earlier than 2015.

What's next?
The boards timeline indicates issuance of a final standard in the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted outreach on some of the more significant changes.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377).

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

In brief

Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Dataline A look at current financial reporting issues


No. 2012-07 August 9, 2012 Whats inside: Overview .......................... 1
At a glance ...............................1 Background .............................1

Revenue from contracts with customers Ready, set, redeliberate.


Overview
At a glance The FASB and IASB (the boards) met on July 19, 2012 to begin redeliberating their joint revenue recognition project. The discussions were focused on concerns raised through comment letters and roundtable discussions, and other feedback received. The boards reached tentative decisions at their July meeting on identifying separate performance obligations, performance obligations satisfied over time, and onerous performance obligations. They also discussed the accounting for licenses, but did not reach any decisions and will continue to redeliberate this topic at a future meeting. The boards plan to complete all major redeliberations by the end of 2012. A final standard is expected during the first half of 2013 with an effective date no earlier than January 1, 2015. Full retrospective application, with certain reliefs, will be required unless the boards change their current position. This topic is planned for discussion at a future meeting. Background .1 The boards issued a revised exposure draft on revenue recognition in November 2011 (the 2011 exposure draft). They decided to re-expose the proposed revenue guidance to avoid unintended consequences from applying the final standard. Refer to Dataline 201135, Revenue from contracts with customers: The proposed revenue standard is reexposed, for a detailed discussion of the proposed guidance. .2 The redeliberations will focus on feedback received on the 2011 exposure draft through comment letters and roundtable discussions, and from consultation efforts. Themes from the comment letters and the roundtables are discussed in Dataline 2012-04, Responses are in on the re-exposed proposed revenue standard.

Current developments ....2


Identifying separate performance obligations ..... 2 Performance obligations satisfied over time ................ 5 Licenses ................................... 7 Onerous performance obligations............................ 9

Next steps ....................... 10 Questions ....................... 10 Appendix Redeliberation decisions to date ......... 11

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Dataline

PwC observation: Striking the right balance when addressing the concerns raised by various constituents is critical to the success of the project. The boards are not limiting their redeliberations to the specific topics in the 2011 exposure draft on which they sought comments. The redeliberation plan also includes several additional topics raised by constituents. .3 This Dataline summarizes the boards redeliberations and tentative decisions made during the July board meeting, and the potential effects on certain industries. These decisions are tentative and are subject to change until a final standard is issued.

Current developments
.4 The boards' redeliberations in July focused on enhancing and clarifying the proposed guidance in some areas, and resulted in a wholesale change on one topic. The following topics were discussed: Refining the guidance for identifying separate performance obligations and determining when a performance obligation is "distinct" Clarifying the criteria for when a performance obligation is satisfied over time Clarifying the implementation guidance related to licenses Revising or eliminating the assessment of onerous performance obligations Identifying separate performance obligations .5 A performance obligation is a promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. Identifying performance obligations that should be accounted for separately is essential to properly applying the revenue recognition model. Separate performance obligations are the units of account to which the transaction price is allocated, and satisfaction of those separate performance obligations determines the timing of revenue recognition. .6 The 2011 exposure draft would require an entity to account for each promised good or service as a separate performance obligation if: The entity regularly sells the good or service separately The customer could benefit from the good or service either on its own or together with other resources that are readily available to the customer .7 It also proposed that a bundle of distinct goods or services should be accounted for as a single performance obligation if both of the following criteria are met: The goods or services are highly interrelated and require the entity to provide a significant service of integrating the goods or services into a combined item that the customer has contracted for The entity significantly modifies or customizes the goods or services to fulfill the contract .8 Respondents generally support the principle of identifying separate performance obligations on the basis of distinct goods or services. They have expressed concerns,

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Dataline

however, that the guidance for bundling promised goods or services might sometimes require companies to combine performance obligations that are actually distinct. .9 Questions have been raised about accounting for goods or services provided at the same time as a single performance obligation. The boards have also received significant feedback about the need to clarify the accounting for repetitive or consecutively transferred goods or services. Tentative decisions .10 The boards agreed to retain, but clarify, the principle for identifying separate performance obligations, and refine the guidance for identifying when goods or services are distinct. Indicators of when a good or service is distinct in the context of the contract will be added to help with this assessment. Distinct in the context of the contract means assessing the contract terms and the intent of the contracting parties to determine the performance obligations that exist. Guidance will also be added to help determine whether a series of promised goods or services delivered consecutively is a single performance obligation or multiple separate performance obligations. .11 An entity will account for a promised good or service (or bundle of goods or services) as a separate performance obligation if it meets the revised criteria below. An entity will combine a good or service with other goods or services in the contract if they are not individually separable until a separate performance obligation is identified.

Identifying separate performance obligations:

The promised good or service is capable of being distinct

The customer can benefit from the good or service either on its own or together with other resources readily available to the customer
f

The promised good or service is distinct in the context of the contract

Not highly dependent on or interrelated with other promised goods or services in the contract

.12 The first requirement introduces a hypothetical test to assess whether a good or service could be distinct. This creates a floor for disaggregating goods or services, because the entity cannot account for goods or services separately if the customer cannot benefit from them separately. Click here for additional discussion on identifying performance obligations. .13 The second requirement is an assessment based on what the customer believes it has contracted to receive. This guidance builds on what was included in the 2011 exposure draft. The boards plan to include indicators of when to separate or bundle performance obligations, rather than criteria. This will allow management to apply judgment and make an assessment that reflects the economics of a transaction.

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Dataline

.14 The boards decided to add a new indicator to address concerns about repetitive or consecutively transferred goods or services. The boards also clarified that a series of promised goods or services is one performance obligation if: (a) it is satisfied over time and (b) the same measure of progress is used to depict the transfer of those goods or services to the customer. Click here for additional discussion on repetitive goods or services. .15 This clarification means that management of an entity providing two services to a customer that are both satisfied over time will need to consider whether the measure of progress used to depict the transfer of those services is the same. For example, if labor hours are used to measure progress for one service and cost incurred is used for another service under the same contract, the two services will generally be accounted for as separate performance obligations because different measures of progress are being used. Industry perspectives .16 The majority of comments received in this area were from three industry groups: aerospace and defense; engineering and construction; and technology. Aerospace and defense .17 Many respondents in the aerospace and defense industry believe that the production of each individual unit under a contract is not distinct because the production process is highly interrelated and the items are highly customized to meet the customer's specifications. The 2011 exposure draft could be interpreted to require that each unit produced under a contract is a separate performance obligation because the units are not highly interrelated with each other. .18 The revised guidance allows for judgment and the indicators will help management to make an assessment that reflects the terms and intent of the parties in the contract. Presuming that each unit is capable of being distinct, various conclusions could be reached when considering the indicators and assessing whether each unit is distinct in the context of the contract. An entity will need to weigh all of the indicators to determine whether units should be accounted for as one performance obligation or multiple separate performance obligations. Engineering and construction .19 Many entities in the engineering and construction industry expressed concerns that the 2011 exposure draft does not allow for judgment in determining whether performance obligations should be bundled or accounted for separately. The 2011 exposure draft could be interpreted such that every contract that contains a bundle of highly interrelated and significantly customized performance obligations must be accounted for as a single performance obligation. .20 Performance obligations might be distinct yet also highly interrelated and significantly customized in some situations (for example, a contract with engineering, procurement, and construction services bundled together). Therefore, many in the industry believe that judgment should be allowed to determine whether those performance obligations should be bundled or accounted for separately. The boards' revised guidance will allow for judgment in determining whether to account for performance obligations separately in a way that reflects the terms and intent of the parties in the contract. Technology .21 A number of software entities responded to the 2011 exposure draft raising concerns about the accounting for software deliverables. The principles in the proposed standard could result in virtually all of the deliverables currently included in most software transactions (for example, license, services, post-contract support, etc.) being accounted

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Dataline

for separately. Software companies that recognize licenses and post-contract support as a single unit of account ratably over the contract term under existing guidance could be required to separate the deliverables under the proposed guidance. Revenue might be accelerated as a result. .22 Some respondents believe the 2011 exposure draft is too prescriptive in requiring distinct components to be accounted for as a single performance obligation if goods or services are highly interrelated and significantly customized. For example, when an entity sells an enterprise software license, in some cases, the customer can engage either the entity or a third party to provide customization and integration services. Many industry respondents interpret the proposed guidance to require this arrangement to be accounted for as one performance obligation when the entity provides both the license and the services. This would result in revenue for the entire contract being recognized over time as the services are provided. The accounting would be different if a third party is engaged to provide the customization and integration services, as the entity transfers control of the software at the beginning of the arrangement, resulting in revenue recognition when the license is delivered. .23 The boards' decision addresses some of these concerns by refining the bundling guidance, and removing the criteria and replacing them with indicators to make the guidance less prescriptive. However, entities that currently account for a bundle of promised goods or services as a single performance obligation due to specific requirements of the existing guidance are likely to have to separate the deliverables under the proposed guidance. PwC observation: We believe the boards are moving in the right direction by allowing for more judgment in determining separate performance obligations based on the context of the contract. The use of indicators to help management assess when goods or services should be bundled or accounted for separately will help with the assessment and allow management to apply an approach that better reflects the economics of a transaction.

Performance obligations satisfied over time .24 Performance obligations can be satisfied either at a point in time or over time. The boards proposed in the 2011 exposure draft that an entity transfers control of a good or service over time if at least one of the following two criteria is met: The entity's performance creates or enhances an asset that the customer controls The entity's performance does not create an asset with alternative use to the entity and at least one of the following criteria is met:

- The customer simultaneously receives and consumes the benefits of the entitys
performance as it performs

- Another entity would not need to substantially reperform the work the entity has
completed to date if that other entity were required to fulfill the remaining obligation to the customer expects to fulfill the contract

- The entity has a right to payment for performance completed to date and it

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Dataline

.25 Respondents generally support the guidance for satisfaction of performance obligations over time, but they have asked the boards to clarify the guidance for service contracts. They have also asked the boards to clarify certain items within the criteria, particularly how to assess when an asset has no alternative use and when the entity has a right to payment for performance completed to date. Tentative decisions .26 The boards decided to clarify the criteria to determine when a performance obligation is satisfied over time and refine the guidance to better address service contracts. The indicators of when an asset has no alternative use and when the entity has a right to payment for performance to date will also be clarified. .27 An entity will recognize revenue over time if any of the following criteria are met.

An entity satisfies a performance obligation over time if:

(a) The customer is receiving and consuming the benefits of the entity's performance as the entity performs;

(b) The entity's performance creates or enhances an asset (a work in progress) that the customer controls as the asset is created or enhanced; or (c) The entity's performance does not create an asset with an alternative use to the entity and the customer does not have control over the asset created, the entity has a right to payment for performance completed to date, and it expects to fulfill the contract.

.28 The first criterion generally addresses service contracts where no asset is created and a customer consumes the services as they are provided. Management should assess if another entity would need to substantially reperform the work completed to date to fulfill the remaining obligation to the customer to determine if the customer obtains the benefits as the entity performs. Contractual or practical limitations that prevent an entity from transferring a remaining performance obligation to another entity are not considered in this evaluation. .29 The second criterion addresses transactions where an asset is created and the customer controls that asset as it is created. Management should apply the guidance on transfer of control to determine whether the customer obtains control of the asset as it is created. .30 The last criterion addresses situations where the customer does not control an asset as it is created. Management will need to consider whether the asset being created has an alternative use to the entity and whether the entity has a right to payment for performance to date. .31 The boards clarified that the assessment of whether an asset has an alternative use should be made at the inception of the contract. Management should consider its ability to redirect a product that is partially completed to another customer, considering both contractual and practical limitations. A substantive contractual restriction that limits
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Dataline

managements ability to redirect the asset would indicate the asset has no alternative use. Practical limitations, such as significant costs required to rework the asset so it could be directed to another customer, could also indicate that asset has no alternative use. .32 To conclude it has a right to payment, an entity must be entitled to payment for performance completed to date even if the customer can terminate the contract for reasons other than the entity's non-performance. A specified payment schedule does not by itself indicate the entity has a right to payment for performance to date. The assessment of the enforceability of the right to payment should include consideration of the contract terms and any legal restrictions or requirements that could override the contract terms. The right to payment should compensate the entity at an amount that reflects the selling price of the goods or services provided to date. For example, this might be an amount that covers an entity's cost plus a reasonable profit margin. PwC observation: The boards clarifications did not change the substance of the guidance in the 2011 exposure draft. Management will need to apply judgment when assessing the criteria for performance obligations satisfied over time, especially when assessing whether assets have an alternative use and whether the entity has a right to payment for performance completed to date. Entities that sell highly customized products that can only be used by a single customer and entities that are the only provider of products for a specific customer might conclude that they do not create assets with an alternative use. Where these entities have the right to payment as products are manufactured, they will be required to recognize revenue over time. This might result in recognizing revenue earlier than other entities that sell products with an alternative use.

Licenses .33 A license is the right to use an entity's intellectual property including, among others: software and technology; media and entertainment rights (such as motion pictures and music); franchises; patents; trademarks; and copyrights. .34 The 2011 exposure draft would require an entity to recognize revenue from granting the right to use intellectual property when the customer obtains control of that right. This occurs when control of licensed rights transfers to the customer, but is no earlier than the beginning of the license period. .35 Many respondents have commented that the proposed accounting might not reflect the economics of certain license arrangements. They are also concerned that revenue could be recognized earlier than in current practice. They have asked the boards to reconsider the application of the recognition principles to time-based licenses, licenses containing restrictions on use, and licenses bundled with service contracts. Tentative decisions .36 The boards discussed whether the implementation guidance should be clarified to focus on whether a license is distinct from other promised goods or services in an arrangement. Revenue from a license that is distinct would be recognized when control of the license transfers to the customer. A license that is not distinct from other goods and services in a contract would be bundled with those goods or services, with revenue recognized as those goods and services are transferred to the customer.

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Dataline

.37 The boards decided that the implementation guidance should be enhanced, but did not make any decisions. They specifically discussed the accounting for time-based licenses and licenses that contain restrictions on use of the licensed asset. .38 The boards debated whether revenue from time-based licenses should be recognized over time or at a point in time. Some board members felt an entity has an implied obligation in a time-based license that is not separable from the license, such as an obligation to protect its intellectual property or maintain its brand. They argued that, as a result, revenue should be recognized over the license term. The majority of board members, however, felt this implied obligation is not an obligation specific to the customer and therefore, it should not affect whether the license is distinct or the timing of revenue recognition. Click here for additional discussion on licenses. .39 The boards also debated the accounting for licenses that contain restrictions on their use. Some board members felt a restriction on the use of a license means control has not transferred to the customer and therefore, revenue should be recognized over the license term. Most board members viewed these restrictions as a characteristic of the license that should not affect when control of the license transfers to the customer. .40 The boards directed their staff to perform additional analysis on how the guidance would apply to different types of licenses as a result of these debates. Further discussion is expected at a future meeting. Industry perspectives Entertainment and media .41 Many constituents in the entertainment and media industry are concerned that the control-based criteria could result in immediate revenue recognition from the licensing of intellectual property. They believe this approach is inconsistent with the economic substance of certain license arrangements, such as licenses of digital content or a portfolio of content. Constituents believe that the standard should be flexible enough to account for the economic substance of different license arrangements, which in some cases would result in recognizing revenue over the period of benefit to the customer. .42 Some constituents have also raised concerns about applying the same accounting to both perpetual and time-based licenses. They argue that the two types of licenses are economically different and therefore, should be accounted for differently. They believe revenue from perpetual licenses should be recognized when the license transfers to the customer, while revenue from time-based licenses should be recognized over the license period. .43 Many long-term license arrangements for film and television content contain licensor-imposed restrictions. These might include restrictions (time-based or usagebased) on the right to use the license during the license term or constraints on the frequency and timing of the use of the license. For example, it is common for a licensor of an episodic television series to specify how the episodes should be sequenced, the frequency of airing, and over what time frame the episodes may be aired. Many respondents highlighted that significant judgment will be required to determine when control transfers due to these complexities. They believe additional clarity is needed to avoid inconsistent application of the guidance to such arrangements. Technology .44 Some software entities are opposed to recognizing revenue over time as this approach differs from their current practice of recognizing revenue when the license is delivered. Other entities that currently recognize software licenses over time would

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Dataline

prefer to retain their current practice. The boards ultimate conclusions about the accounting for licenses will likely change current practice for one of these groups. PwC observation: Accounting for licenses has been an area of debate from the beginning of the project. The original exposure draft issued in 2010 proposed an approach that distinguished between exclusive and non-exclusive licenses. Revenue would have been recognized over time for exclusive licenses and at a point in time for non-exclusive licenses. Constituents raised concerns about this approach, so the boards decided to remove the reference to exclusivity from the proposed guidance and require revenue recognition upon transfer of the licensed rights. There are differing views among board members on the timing of revenue recognition for time-based licenses and licenses containing restrictions on use. Regardless of the direction the boards take, the timing of revenue recognition for licenses of intellectual property is likely to change for some entities as compared to current practice.

Onerous performance obligations .45 The 2011 exposure draft would require an entity to recognize a liability and a corresponding expense if a performance obligation satisfied over more than one year is onerous. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to it. The lowest cost of settling a performance obligation is the lower of: (a) what an entity would pay to exit the performance obligation and (b) the cost of satisfying the performance obligation. .46 Respondents generally disagree with the proposed accounting for various reasons. Some argue that the assessment of onerous obligations relates to cost, not revenue recognition, and therefore, should not be included in a revenue standard. Others suggest that if guidance for recording provisions for onerous obligations is included in the final standard, the assessment should be made at the contract level or a higher level to better reflect how contracts are negotiated with customers. The boards have received comments about whether the scope of the assessment should be limited to only performance obligations satisfied over more than one year and they have also been asked to clarify which costs would be included in the assessment. Tentative decisions .47 The boards decided to remove the requirement to assess onerous performance obligations from the final standard. They will instead retain the existing guidance in U.S. GAAP and IFRS. .48 The FASB will carry forward existing U.S. GAAP guidance, which includes the onerous loss guidance in ASC 605-35, Construction-type and Production-type Contracts, and other industry-specific guidance. The guidance carried forward will be limited to those contracts currently in the scope of existing guidance. The IASB decided that contracts with customers will be subject to IAS 37, Provisions, Contingent Liabilities and Contingent Assets. Industry perspectives .49 The boards decision to remove guidance on onerous performance obligations from the proposed standard addresses concerns raised by constituents across industries. Most industries have voiced concerns about the complexity of accounting for onerous performance obligations, the potential diversity in the application of the guidance, and

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Dataline

the potential for uneconomic outcomes when a contract is profitable on an overall basis. Removal of this guidance will address these concerns. Aerospace and defense, Engineering and construction .50 The aerospace and defense, and engineering and construction industries apply the onerous loss guidance today. The boards decision will result in these industries continuing to apply current guidance to their contracts under U.S. GAAP. It is unclear whether the entities applying IFRS will continue to follow the guidance in IAS 11, Construction Contracts, or will be subject to the guidance in IAS 37. PwC observation: We support the boards decision to remove the onerous test from the proposed guidance. We believe that the accounting proposed in the 2011 exposure draft might not accurately reflect the economics of certain arrangements. It is unclear, however, how existing guidance, including scope, will be carried forward and retained. Most of the boards' discussions focused on ASC 605-35 and IAS 37. The boards will need to ensure the scope of the retained guidance is clear if they are to capture all contracts currently subject to such guidance. The IASB will also need to consider whether to carry forward the loss-making contracts guidance in IAS 11.

Next steps
.51 The boards' redeliberation plan includes several key issues still to be discussed. These include the "reasonably assured" constraint on recognition of variable consideration, collectibility, time value of money, contract combination and modification, disclosures, and transition. .52 A final standard is expected in the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted consultation on some of the more significant changes.

Questions
.53 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377 or 1-973-236-7804).

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Dataline 10

Appendix Redeliberation decisions to date


The table below summarizes the decisions reached by the boards to date. These decisions are tentative and subject to change until a final standard is issued.

Topic
Identifying separate performance obligations

November 2011 Exposure Draft


A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with resources readily available to the customer A bundle of goods or services is accounted for together as one performance obligation if both of the following criteria are met: The goods and services are highly interrelated and the entity provides a significant service of integrating goods and services into the combined item that the customer has contracted for The entity is contracted by the customer to significantly modify or customize the goods or services

Tentative Decision
The boards decided that an entity should account for a promised good or service (or a bundle of goods or services) as a separate performance obligation only if both of the following criteria are met: The promised good or service is capable of being distinct because 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 The promised good or service is distinct within the context of the contract because the good or service is not highly dependent on, or highly interrelated with, other promised goods or services in the contract The boards agreed that the assessment of whether a promised good or service is distinct in the context of the contract should be supported by indicators, such as: The entity does not provide a significant service of integrating the goods or services The customer was able to purchase or not purchase the good or service without significantly affecting the other promised goods or services in the contract The good or service does not significantly modify or customize another good or service promised in the contract The good or service is not part of a series of consecutively delivered goods or services promised in a contract that meet the following two conditions: 1. The promises to transfer those goods or services to the customer are performance obligations that are satisfied over time 2. The entity uses the same method for measuring progress to depict the transfer of those goods or services to the customer The boards decided to remove the practical expedient that permitted an entity to account for two or more distinct goods or services as a single performance obligation if those goods or services have the same pattern of transfer to the customer.

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Dataline 11

Topic
Performance obligations satisfied over time

November 2011 Exposure Draft


A performance obligation is satisfied over time if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity and one of the following criteria is met: The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially reperform the task(s) if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fulfill the contract

Tentative Decision
The boards decided to make the following refinements to the criteria for determining whether an entity satisfies a performance obligation over time and, hence, recognizes revenue over time: Retain the criterion that considers whether the entitys performance creates or enhances an asset that the customer controls as the asset is created or enhanced Combine the simultaneous receipt and consumption of benefits criterion and the another entity would not need to substantially reperform proposed criterion into a single criterion that would apply to pure service contracts Link more closely the alternative use criterion and the right to payment for performance completed to date criterion by combining them into a single criterion The boards also decided to clarify aspects of the alternative use and right to payment for performance completed to date criteria. For example: The assessment of alternative use is made at contract inception and that assessment considers whether the entity would have the ability throughout the production process to readily redirect the partially completed asset to another customer. The right to payment should be enforceable and, in assessing the enforceability of that right, an entity should consider the contractual terms as well as any legislation or legal precedent that could override those contractual terms.

Licenses and rights to use

The promised rights are a performance obligation that the entity satisfies when the customer obtains control (that is, the use and benefit) of those rights. An entity should consider whether the rights give rise to a separate performance obligation or whether the rights should be combined with other performance obligations in the contract.

The boards discussed possible refinements to the implementation guidance on accounting for licenses. They directed the staff to perform additional analysis and bring the topic back to a future meeting.

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Dataline 12

Topic
Onerous performance obligations

November 2011 Exposure Draft


An entity should recognize a liability and corresponding expense if a performance obligation that is satisfied over a period of time is onerous. The performance obligation will not need to be assessed if it is satisfied over a period less than one year. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of transaction price allocated. The lowest cost of settling a performance obligation is the lower of the following: The costs directly related to satisfying the performance obligation The amount the entity would have to pay to exit the performance obligation

Tentative Decision
The boards decided to remove this guidance from the scope of the revenue standard. As a result, the IASB decided that the requirements for onerous contracts in IAS 37, Provisions, Contingent Liabilities and Contingent Assets, should apply to all contracts with customers in the scope of the revenue standard. The FASB decided to retain existing guidance related to the recognition of losses arising from contracts with customers, including the guidance relating to construction-type and productiontype contracts in Subtopic 605-35, Revenue RecognitionConstruction-Type and Production-Type Contracts. The FASB also indicated it would consider whether to undertake a separate project to develop new guidance for onerous contracts.

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Dataline 13

Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com Roshini Prasad Senior Manager Phone: 1-973-236-4412 Email: roshini.prasad@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

In brief An overview of financial reporting developments


FASB and IASB redeliberate to make the proposed revenue standard less "onerous"
What's new?
The FASB and IASB (the boards) met on July 19 to discuss their joint project on revenue recognition. They reached decisions on identifying separate performance obligations, performance obligations satisfied over time, and onerous performance obligations. They also discussed the accounting for licenses, but did not reach any decisions. The decisions reached are tentative and subject to change. Other key issues still to be redeliberated include the "reasonably assured" constraint on recognition of variable consideration, collectibility, time value of money, contract combination and modification, disclosures, and transition.

No. 2012-28 July 20, 2012

What are the key decisions?


Identifying separate performance obligations A key step in the revenue recognition model is identifying the separate performance obligations in a contract. The boards agreed to clarify the principle for identifying separate performance obligations and refine the criteria for identifying when goods or services are distinct. An entity will account for a promised good or service (or a bundle of goods or services) as a separate performance obligation if it: (a) could be distinct (the customer can benefit from the good or service either on its own or together with other resources readily available to the customer); and (b) is distinct based on the substance of the contract (not highly dependent on or interrelated with other promised goods or services in the contract). The boards also agreed to include indicators of when a good or service is not distinct to help with this assessment. The indicators include guidance to assist in determining whether a series of promised goods or services in the contract is a single performance obligation or a series of distinct performance obligations. Performance obligations satisfied over time The boards clarified the criteria to determine when a performance obligation is satisfied over time. The guidance was refined to better address service contracts. The indicators of

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In brief

when an asset has "no alternative use" and when the entity has a right to payment for performance to date were also refined. The boards agreed that an entity satisfies a performance obligation over time if: (a) the customer is receiving and consuming the benefits of the entity's performance as the entity performs (i.e., another entity would not need to substantially re-perform the work completed to date); (b) the entity's performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or (c) the entity's performance does not create an asset with an alternative use to the entity, the entity has a right to payment for performance completed to date, and it expects to fulfill the contract. Accounting for licenses The boards agreed that the implementation guidance on accounting for licenses should be enhanced, but did not make any decisions on this topic. We expect further discussion at a future meeting. The boards requested their staffs to conduct further analysis on applying the guidance to various types of licenses, including the pattern of revenue recognition (over time or at a point in time) for term-based licenses. The staffs were also asked to consider the effect of contractual restrictions on revenue recognition. It was unclear to the boards how the proposed guidance would apply in these situations. Onerous performance obligations The boards decided to remove the requirement to assess onerous performance obligations from the final standard. This decision was in response to concerns raised by constituents about the difficulties in applying the proposed guidance. The boards decided instead to retain current onerous loss guidance within U.S. GAAP and IFRS.

Is convergence achieved?
Convergence is expected for revenue recognition, as the same principles will be applied to similar transactions under both frameworks. Differences might continue to exist to the extent that the guidance requires reference to other standards before applying the guidance in the revenue standard.

Who's affected?
The proposal will affect most entities that apply U.S. GAAP or IFRS. Entities that currently follow industry-specific guidance should expect the greatest impact.

What's the effective date?


We anticipate the final standard to have an effective date no earlier than 2015.

What's next?
The boards' timeline indicates issuance of a final standard in the first half of 2013. The boards will continue to redeliberate over the next several months and perform targeted outreach on some of the more significant changes.

Questions?
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377).
National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com In brief 2

Authored by:
Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Craig Robichaud Partner Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Eli Seller Senior Manager Phone: 1-973-236-4261 Email: eli.e.seller@us.pwc.com

In brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Dataline A look at current financial reporting issues


Responses are in on the re-exposed proposed revenue standard Constituents voice their supportand concerns
Overview
At a glance The FASB and IASB (the "boards") released an updated exposure draft, Revenue from Contracts with Customers, on November 14, 2011 (the "2011 Exposure Draft"). The boards received approximately 360 comment letters in response to the updated exposure draft, down significantly from the nearly 1,000 comment letters received on the exposure draft released in June 2010 (the "2010 Exposure Draft"). Since issuing the updated exposure draft, the boards have continued extensive outreach efforts, including four public and numerous private, industry-focused roundtables. Refer to Appendix B for the boards' proposed project timeline, which details the expected timing of discussion of outstanding issues. The boards asked whether the proposed guidance is clear, and specifically requested feedback on: (1) performance obligations satisfied over time; (2) presentation of the effects of credit risk; (3) recognition of variable consideration and the revenue recognition constraint; (4) the scope of the onerous performance obligation test; (5) disclosures in interim financial reports; and (6) transfer of non-financial assets that are outside an entity's ordinary activities (for example, the sale of property, plant and equipment). Respondents have commented on the questions asked by the boards, but also on a number of other areas, including the application of time value of money, transition, and annual disclosures. Industries have also asked the boards to address or clarify the application of the proposals to certain industry-specific issues. The boards have not yet decided on the effective date of the standard, but have said that it will not be effective earlier than January 1, 2015. Early adoption will not be permitted under U.S. GAAP, but will be permitted under IFRS.

No. 2012-04 May 31, 2012 Whats inside: Overview .......................... 1


At a glance ...............................1 Background ............................ 2

Comment letter trends and roundtable discussions ....................3


Performance obligations satisfied over time ................ 4 Presentation of the effects of credit risk ......................... 4 Recognition of variable consideration and the revenue recognition constraint ............................. 5 Scope of onerous performance obligation test ........................................ 6 Disclosures .............................. 7 Transfer of non-financial assets that are outside an entity's ordinary activities ............................... 8 Time value of money .............. 8 Transition ............................... 9

Industry perspectives ... 10 Next steps .......................22 Questions .......................22 Appendix A Summary of significant comment letter topics by industry group ............23 Appendix B Boards' proposed project timeline .......... 24

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Dataline

Background .1 The boards decided unanimously to re-expose the proposed revenue guidance because of the importance of the revenue number to all entities and to avoid unintended consequences from applying the standard. This decision was made despite the 2011 Exposure Draft not significantly changing the core model proposed in the 2010 Exposure Draft, which requires the following five steps: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price and amounts not expected to be collected Allocate the transaction price to separate performance obligations Recognize revenue when (or as) each performance obligation is satisfied .2 Several key differences exist between the 2010 and 2011 Exposure Drafts, despite the core model remaining largely unchanged. Changes were made in several areas including identifying separate performance obligations, determining the transaction price, accounting for variable consideration, transfer of control, and accounting for contract costs, among others. Refer to Dataline 2011-35, Revenue from contracts with customers: The proposed revenue standard is re-exposed, for a detailed discussion of the key changes. .3 The boards continue to focus on industry outreach efforts, and have held roundtables to gauge reactions and understand concerns with the 2011 Exposure Draft. Key topics raised in these meetings include identifying separate performance obligations, applying time value of money, practical challenges with applying the onerous performance obligation test, allocation of transaction price, disclosures and transition. PwC observation: Striking the right balance in addressing these concerns is critical to the success of the project given the proposed standard will eliminate industry specific guidance. Respondents appear to believe the boards are heading in the right direction based on the volume and content of comment letters. The remaining concerns with the exposure draft are not insignificant, however, and the boards will likely need to further address certain areas before issuing a final standard. .4 This Dataline addresses the areas of focus in roundtables and in comment letters received by the boards on the proposed standard. References within this Dataline to the "exposure draft" or "proposed standard" refer to the exposure draft issued in November 2011, unless otherwise indicated.

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Dataline

Comment letter trends and roundtable discussions


.5 The boards revised various aspects of the proposed standard in response to extensive feedback received on the 2010 Exposure Draft. The boards requested comments on those key changes as well as feedback on whether the guidance is clear and if it will result in information that reflects the economic substance of transactions. Respondents were asked to comment on the following topics: Performance obligations satisfied over time Presentation of the effects of credit risk Recognition of variable consideration and the revenue recognition constraint Scope of the onerous performance obligation test Disclosures in interim financial reports Transfer of non-financial assets that are outside an entity's ordinary activities .6 Other topics such as time value of money, disclosures, and transition continue to cause concern. .7 The number of industry-specific comments decreased since the 2010 Exposure Draft, but a number of concerns remain. The chart below depicts the volume of comment letters by industry: Comment letters by industry
180 160 140 120 100 80 60 40 20 0

2010 Exposure Draft 2011 Exposure Draft

.8 Certain industry groups, such as engineering and construction, consumer and industrial products, and technology, sent far fewer letters on the 2011 Exposure Draft compared to the 2010 Exposure Draft. The volume of letters from other industry groups, such as telecommunications, automotive and entertainment and media, remained generally consistent with those received on the 2010 Exposure Draft.

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Dataline

PwC observation: We believe the number of letters significantly decreased because the boards addressed many of the questions and concerns raised in response to the 2010 Exposure Draft. Areas that caused significant concern in the 2010 Exposure Draft, such as the accounting for services, the identification of a contract, collectibility, warranties, and licenses, are addressed in the 2011 Exposure Draft to the satisfaction of many. Challenges identified by certain industries around separation of performance obligations and allocation of transaction price are also addressed. Proposed guidance that continues to be unpopular across all industry groups includes accounting for the time value of money, the application of the onerous test at the performance obligation level, the level of disclosures required, and retrospective transition.

Performance obligations satisfied over time .9 Guidance was added to the 2011 Exposure Draft on how to determine whether performance obligations are satisfied over time. This was added in response to feedback that the 2010 Exposure Draft lacked guidance in this area, especially for service contracts. .10 The proposed standard is now clear that performance obligations can be satisfied either at a point in time or over time. Control is transferred and revenue is recognized over time if certain criteria are met. .11 Respondents generally agree with the additional guidance, but confusion remains about whether a contract for the delivery of repetitive goods or services is a single performance obligation or multiple performance obligations. For example, a two-year contract for a daily cleaning service could be viewed as a single performance obligation satisfied over time or many daily distinct performance obligations. PwC observation: Support for the additional guidance was not unexpected as it clarified the accounting for most service arrangements. Significant progress has been made on this issue, despite there still being areas where clarity is needed. We agree with the guidance suggested, but further clarification is needed around the delivery of repetitive goods or services. This determination might affect the pattern and timing of revenue recognition, the accounting for contract modifications, and the onerous performance obligation test.

Presentation of the effects of credit risk .12 The presentation of the effects of credit risk, meaning the consideration an entity believes will not be collected, continues to get attention from respondents. The 2011 Exposure Draft proposes that an entity present any allowance for receivable impairment losses in a separate line item adjacent to revenue. Both the initial assessment and any subsequent changes to the estimate are recorded in this line.

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Dataline

.13 Respondents generally disagree with presenting the effects of credit risk adjacent to revenue and recommend entities continue to record credit risk as an operating expense that does not impact gross profit. Most respondents have indicated that recognizing credit risk adjacent to the revenue line item introduces complexities that do not exist today. Other feedback has focused on whether the effects of credit risk need to be presented on the face of the income statement or whether disclosure would be sufficient. Respondents appear to agree that credit risk should not impact transaction price. PwC observation: Only a few respondents have raised concerns about collectibility no longer being a hurdle to revenue recognition. It appears that most preparers favor such a change in the proposed standard. Investors, on the other hand, are concerned about eliminating the "collectibility is reasonably assured" criteria under U.S. GAAP. They believe the proposed constraints on revenue are not effective enough to prevent entities from recording revenue prematurely. Investors also tend to agree with presenting revenue and any impairment losses (and reversals) as a separate line item adjacent to the revenue line, consistent with that proposed in the exposure draft. This contrasts with the views of preparers, who also suggest that the presentation of credit risk on the face of the income statement might not provide added benefit in all situations. We believe that allowing entities to present this information in the notes to financial statements would be equally useful.

Recognition of variable consideration and the revenue recognition constraint .14 The 2011 Exposure Draft provides guidance on the accounting for consideration that is variable or contingent on the outcome of future events (for example, discounts, incentives, and royalties). An estimate of variable consideration is included in the transaction price and allocated to each separate performance obligation. Variable consideration is only recognized as revenue when the entity is reasonably assured to be entitled to that amount. An entity needs to have predictive experience with similar performance obligations for the entity to be reasonably assured that it will be entitled to that consideration. .15 The proposed standard includes an exception to this principle for certain transactions. An entity that licenses intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service is reasonably assured to be entitled to the royalty payment when those future sales occur. .16 Treatment of variable consideration was different in the 2010 Exposure Draft, as the transaction price was constrained rather than the cumulative revenue recognized. There were a number of unintended consequences of that treatment, which led the boards to propose a different constraint. .17 Some respondents support the exception for sales-based royalties, but many oppose it, particularly those in the technology, and retail and consumer industries. Concerns were raised that it could drive different accounting treatments for economically similar transactions, and should therefore either be eliminated or be expanded to include other arrangements where consideration is based on the customers' sales or where consideration is based on other customer performance measures.

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Dataline

PwC observation: Feedback from constituents has been consistent--revenue recognition should be constrained if there is not sufficient evidence to support its recognition. Opinions diverge, however, on what constitutes sufficient evidence, with some believing the amounts should be "virtually certain" and others supporting "probable" or "more likely than not" thresholds. The boards have proposed a qualitative threshold, as opposed to a quantitative one, but more clarity might be needed to achieve that objective. We agree with respondents who said an exception is not needed for sales-based royalties. The proposed guidance on whether an entity's experience is predictive should be able to sufficiently address sales-based royalty arrangements without the need for an exception.

Scope of onerous performance obligation test .18 A performance obligation was onerous in the 2010 Exposure Draft if the present value of the costs to satisfy the obligation exceeded the transaction price allocated to it. There was no scope limitation and this test applied to all performance obligations. The boards revised the scope of the test to apply only to performance obligations that an entity satisfies over time and over a period greater than one year in response to concerns raised. .19 The boards now propose that a performance obligation is onerous only if the lowest cost of settling the performance obligation, being either the cost to fulfill or the cost to exit, exceeds the transaction price allocated to that performance obligation. A liability and a corresponding expense are recognized if the performance obligation is onerous. .20 Most respondents continue to disagree with assessing performance obligations to determine whether an obligation exists, citing that the accounting does not reflect the commercial substance in many arrangements. Respondents also believe that recording a loss at the performance obligation level for overall profitable contracts could result in misleading information. They contend that maintaining records at the performance obligation level is impractical and the cost and effort outweigh the benefits. Even those entities that currently apply an onerous test for long-term contracts do so at the contract level, not the performance obligation level. PwC observation: The onerous test continues to be universally disliked by industries that do not apply construction contract accounting today. Assessing performance obligations each reporting period to determine whether they are onerous will be challenging for many entities and it is questionable whether the benefits of making such an assessment will outweigh the cost or effort. We recommend that, if the assessment is retained in the final standard, it should be performed at the contract level or higher. Assessing whether a performance obligation is onerous as currently prescribed might not reflect the underlying economics of an arrangement. An entity might enter into loss-making performance obligations or loss-making contracts because other benefits are received, for example.

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Dataline

Disclosures .21 The boards believe there is significant improvement to be made to existing revenue disclosures in light of criticism by regulators and users of financial statements. They have therefore proposed a comprehensive list of disclosures, for both annual and interim financial statements. .22 The proposed disclosures are intended to enable users of financial statements to understand the amount, timing, and judgments around revenue and the corresponding cash flows. Required disclosures include qualitative and quantitative information about revenue, such as significant judgments made and changes in those judgments, rollforward of balances, and assets recognized for the costs to obtain or fulfill contracts. .23 The boards have proposed that interim financial statements should include most of the same disclosures required in annual financial statements, if material. .24 Preparers of financial statements acknowledge the efforts made by the boards to enhance disclosures. Most believe, however, that the pendulum has swung too far. Key concerns raised by preparers include: Required disclosures are too extensive and might be based on information not used by management to manage the business The costs of providing the disclosures will exceed perceived benefits The disclosure requirements do not meet the boards' overall objective of increasing transparency and understanding of revenue recognition because they "clutter" the disclosures The extent of the disclosures required appears counterintuitive to the objectives in ongoing discussions at the IASB and FASB to improve disclosure effectiveness .25 Investors support the disclosure requirements, for both interim and annual financial statements. They believe the requirements are comprehensive and will significantly enhance users' understanding of an entity's revenue recognition. Investors acknowledge preparers' concerns around the volume of disclosures required, but believe the requirements are reasonable given the importance of revenue. .26 Investors also recommend that nonpublic companies should not be exempt from certain disclosure requirements and should not be treated differently than public companies, a view not shared by most other respondents. PwC observation: The boards are trying to improve the quality of disclosures, while achieving the right balance between the benefits to users of having that information and the costs to entities to prepare it. This is a fair objective given the limited disclosure requirements today. However, both interim and annual disclosure requirements proposed in the standard continue to be an area of controversy. To find the right balance, the boards have discussed holding a workshop that includes both preparers and users of financial statements to reconcile what is most critical to have in the financial statement disclosures. We agree that revenue disclosures generally need to be enhanced. We agree with preparers, though, that the proposal requires too many disclosures and risks obscuring useful information. Removing certain disclosure requirements will better balance the objectives of the boards, desires of users and the burden on preparers.

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Dataline

For example, we question the need to disclose items not used by management to manage the business, and wonder whether such disclosures will be meaningful. The proposed interim disclosures appear inconsistent with the principle that interim reporting should reflect only significant changes since the last annual reporting period. A majority of preparers who responded have expressed concerns about both the annual and interim disclosure requirements, despite the boards only asking for input on interim disclosures. We believe the boards should reconsider their position on this issue.

Transfer of non-financial assets that are outside an entity's ordinary activities .27 The boards have proposed that the guidance on transfer of control and recognition of variable consideration in the proposed standard should also be applied to transfers of non-financial assets that are not an output of an entity's ordinary activities such as property, plant and equipment. .28 This guidance would determine when an entity should derecognize an asset and would provide guidance on how to measure any gain or loss on sale. The boards asked for specific feedback in this area as the recognition constraint would have an effect on the gain or loss when the consideration is variable. .29 Most respondents did not comment on this area. Those that did respond generally agree with applying the guidance to non-financial assets. Others disagree, advocating that current guidance be retained. PwC observation: This is an area that might have gone unnoticed by many respondents. We support applying the guidance in the proposed standard to the transfer of non-financial assets that are not part of an entitys ordinary activities. We recommend the scope of the guidance be clear, given there are currently different derecognition models and measurement guidance depending upon the nature of the item sold and whether an entity is applying U.S. GAAP or IFRS.

Time value of money .30 The proposed standard specifies that an entity reflect the time value of money to determine the transaction price if the contract has a significant financing component. .31 An entity that expects, at contract inception, that the period between payment by the customer and the transfer of goods or services to the customer will be one year or less does not need to consider the time value of money. This is a practical expedient introduced to address concerns about the burden and complexity of applying this guidance. .32 Respondents generally understand the conceptual basis for incorporating the time value of money into the transaction price, but continue to express concerns over the complexities and practical challenges associated with it. They are particularly concerned about the need to implement systems and processes to account for the time value of money. The majority of respondents across industries argue that the cost outweighs the benefit to users, and recommend this requirement be removed.

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.33 Some suggest that the practical expedient be removed since it is arbitrary and does not provide adequate relief. PwC observation: The volume of feedback in this area and the general direction of that feedback came as no surprise. Feedback through roundtables and other forums has been consistent with that noted in the comment letters. Generally, respondents (including users) believe that an entity should account for the time value of money when it is apparent that the contract contains a significant financing component; however, respondents are concerned with the complexity of applying this guidance. We understand the conceptual merit of considering the time value of money to determine the transaction price, but we also share constituent's concerns. The practical challenges of applying this guidance could outweigh the benefit to users in some situations. System and process changes will also be needed, at potentially high cost, for preparers to apply the guidance.

Transition .34 It is unclear when a final standard will be issued, but it will likely be early 2013. The boards have not yet decided on the effective date of the standard, but have said that it will not be effective earlier than January 1, 2015. Early adoption will not be permitted under U.S. GAAP, but will be permitted under IFRS. .35 The boards propose that the standard be applied retrospectively, with certain optional reliefs. The boards affirmed that comparability and understandability of revenue recognized before and after adoption of the new standard outweighs concerns raised about costs and efforts of applying the guidance to prior periods. The boards believe entities will have sufficient time between issuance of the standard and the effective date to prepare and compile the necessary information. .36 The boards have provided entities with several practical expedients to ease the burden of transition, as follows: Contracts that begin and end in the same annual reporting period do not need to be restated The transaction price at the date the contract was completed can be used for contracts with variable consideration that were completed on or before the effective date The onerous performance obligation test does not have to be applied to performance obligations in prior periods unless an onerous contract liability was recognized previously Disclosure of the amount of the transaction price allocated to remaining performance obligations and the expected timing of revenue recognition (the ofttermed "maturity analysis") is not required .37 Financial statement preparers acknowledge that retrospective application will provide users valuable information. Their primary concern is the added burden of applying both the proposed standard and current guidance to large and complex multiple-element arrangements and long-term contracts that span multiple periods. Many respondents believe maintaining a dual reporting system for up to three years is not practical or cost effective.

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.38 Other concerns raised by respondents point to potential unintended consequences from retrospective application, including implications on previously filed tax returns or compensation arrangements. .39 An overwhelming number of respondents recommend the boards allow some form of prospective adoption of the final standard or at least allow prospective application when it is not practical for entities to apply the standard retrospectively. Many also support permitting early adoption for all entities, not just those under IFRS. .40 Although users of financial statements acknowledge the burden of retrospective application on preparers, they support the proposed transition method and believe it is necessary for meaningful financial analysis. Instead of providing an option for another transition method, as proposed by preparers, users suggest that a better approach would be to delay the effective date of the proposed standard to give preparers more time to implement. PwC observation: Transition has been and continues to be one of the most loudly voiced concerns. While retrospective application might increase consistency across periods, the effort involved might outweigh the benefits. The practical expedients reduce some challenges, but there could be other implications which need to be considered, including statutory or regulatory requirements.

Industry perspectives
.41 Industry groups have been active in commenting, both verbally and in writing, on the 2011 Exposure Draft. They continue to express concerns with aspects of the proposed standard, some of which are common themes across multiple industries, while others are more specific to one industry. .42 This section summarizes specific issues and concerns raised by industries through the boards' outreach efforts. Some of the concerns raised during this outreach period, while less in volume than heard in relation to the 2010 Exposure Draft, remain significant to specific industries. The boards might need to reconsider certain proposals before issuing a final standard if they are to resolve some of these issues. .43 Certain industry groups are still struggling with aspects of the proposed standard. For example, the telecommunications industry continues to be concerned about the allocation of the transaction price in bundled arrangements and accounting for contract costs. The automotive industry has different views on how to account for non-cash incentives, while the entertainment industry is concerned with revenue recognition for license arrangements. The volume of comment letters remained relatively flat for these industries; however, the content of the comments is more focused on these specific issues. Aerospace and defense .44 The table below captures topics that remain top of mind for this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic.

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Summary of comments

Satisfaction of performance obligations Disclosures Onerous test Contract modifications Separate performance obligations Time value of money Transition 0% 20% 40% 60% 80% 100%

Identification of separate performance obligations .45 A majority of respondents in the aerospace and defense industry believe that a contract for the production of several similar items for a government, such as aircraft, is a single performance obligation since the contract is negotiated and managed on a combined basis. Many in the industry hold the view that the production of each individual unit is not distinct because the production process is highly interrelated and some of the items are highly customized to meet the customer's specifications. Respondents have highlighted that the proposals can be interpreted such that each unit produced under the contract is a separate performance obligation because the units are not highly interrelated with each other. Respondents therefore recommend the boards clarify the guidance. Performance obligations satisfied over time .46 Revenue should be recognized by measuring the progress toward satisfaction of a performance obligation if it is satisfied over time. Most respondents agree with the proposals, but question the timing of cost recognition when an output measure, such as units of delivery, is used to measure progress. Many are concerned that contract costs will be expensed as incurred as a fulfillment cost. This is a change from today's contract accounting guidance, which respondents feel will distort the margin during contract performance and therefore, does not reflect the economics of a contract that is satisfied over time. These respondents recommend that entities be allowed to use a systematic and rational approach for recognizing contract costs to reflect the single overall profit margin of the arrangement. .47 Many aerospace and defense contracts include estimates of rework costs, such as redesign or work-arounds, which are factored into contract estimates as normal costs to deliver highly complex and specialized equipment. The proposed standard requires that costs of wasted materials and inefficiencies be expensed when they are not already factored into the price of the contract. Concerns have been raised that it is difficult to identify when these normal rework costs become incremental to the initial estimate included in the contract. Contract modifications .48 Contract modifications occur frequently in the aerospace and defense industry. These modifications include changes to scope or price, including some that might be unapproved or in dispute (known as "claims"). Generally these modifications are approved after the contractor provides the related service. Respondents believe the proposed standard is unclear on the accounting for such modifications and recommend carrying forward existing guidance on the accounting for contract modification for construction contracts. This existing guidance is similar under IFRS and U.S. GAAP and
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allows for recognition of amounts subject to claims or unapproved change orders in certain circumstances. PwC observation: The aerospace and defense industry is generally satisfied with the direction of the 2011 Exposure Draft. This industry was especially active in working with the boards during their redeliberations to share concerns and related business implications. The boards listened, and many of the concerns expressed by this industry on the 2010 Exposure Draft were addressed. Not surprisingly, the main concerns that remain are those that could drive different accounting results than the contract accounting models used today under both U.S. GAAP and IFRS.

Automotive .49 The table below captures significant topics that concern this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments

Transition Warranties Consideration payable to a customer Disclosure Time value of money 0% 10% 20% 30% 40% 50% 60% 70%

Consideration payable to a customer .50 Automotive manufacturers typically sell vehicles through an independent network of authorized dealers, who then sell the vehicles to the retail consumer. At the same time, the manufacturer commonly offers incentives directly to the retail consumer, including promises to provide free goods or services such as maintenance on the vehicle. Respondents are uncertain as to how to account for these non-cash incentives when they are offered directly to their customer's customer (i.e., the retail consumer). .51 Some believe that the cost of non-cash incentives should reduce the transaction price, similar to cash paid to a customer's customer, since the manufacturer does not perform the services promised. Others believe the promised good or service is a separate performance obligation and some revenue should be deferred at the time of sale to the authorized dealer. To the extent the promised good or service is not regularly sold separately by the manufacturer and its cost is incidental to the cost of the vehicle, some have proposed the boards consider allowing the incentives to be accounted for as a costaccrual. Despite the varying perspectives, most agree that additional clarity on the accounting for non-cash incentives promised to the customer's customer is needed.

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Warranties .52 Accounting for warranties continues to be an area of focus for the automotive industry. The industry supports the boards' proposal that assurance-type warranties should be accounted for as a cost accrual similar to today. The industry remains concerned about the requirement to account for a warranty as a separate performance obligation if there is a service component that the entity is unable to separate. Some do not believe that accounting for the service component of the warranty separately is practical. They also do not believe it represents the underlying economics of the arrangement unless that portion of the warranty is more than incidental to the assurance warranty. Respondents also do not agree that the length of the warranty period should determine whether a warranty includes a service element. Repurchase agreements .53 Automobile manufacturers sell vehicles to customers and often include repurchase or reimbursement options as part of the contract. This is common in arrangements with rental car companies, for example. These agreements are commonly structured as either: (1) the buyer has an option to put the vehicles back to the seller, or (2) the seller guarantees the residual value of the vehicle at the end of a specified term, such as 12 months. .54 The proposed standard results in different accounting for these arrangements. An unconditional obligation to repurchase the vehicle is a lease if the customer has a significant economic incentive to put the vehicle back to the manufacturer. The agreement is a sale if the manufacturer must reimburse the customer for any deficiency between the sales proceeds and a minimum resale value. Any expected reimbursements reduce the transaction price at the time of sale. Respondents believe these are economically similar transactions that should be accounted for the same way. Some respondents have also requested the boards define "unconditional obligation" to avoid diversity in practice, as the repurchase agreements are typically conditional on the vehicle being returned in a certain condition and within a certain time period. PwC observation: The automotive industry has generally supported the overall objectives of the proposed guidance. The remaining concerns, particularly around consideration payable to a customer, require the boards to further clarify guidance in the 2011 Exposure Draft as the guidance is not being consistently interpreted by entities within the industry.

Consumer industrial products .55 The consumer industrial products sector comprises a range of entities involved in the production of goods and delivery of services across a diverse industry base. This includes industrial manufacturing, metals, chemicals, forest products, paper and packaging entities. The wide range of entities in this industry voiced concerns on a variety of issues. Uninstalled materials .56 Respondents have raised concerns with the guidance on uninstalled materials when an entity uses subcontractors who provide as is equipment for installation into a final product or service. The proposed standard requires that the revenue recognized for this performance obligation equal the cost of the equipment acquired from a subcontractor (that is, a zero percent profit margin). Respondents disagree with allocating a zero percent profit margin for goods purchased from a subcontractor contending that the entity is providing the customer a turn-key solution not just passing through the equipment.
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Licenses .57 Franchisors generally do not agree with the proposed accounting for license arrangements with variable consideration. There is specific concern with recognizing royalty revenue prior to the related sale by the franchisee. They believe these arrangements are economically similar to royalties based on a customer's subsequent sale in a license of intellectual property and that revenue should be recognized over time as the royalties are earned. Engineering and construction .58 The table below captures significant topics commented on by this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments

Onerous test Contract costs / uninstalled materials Disclosures Transition Separate performance obligations Contract modifications 0% 20% 40% 60% 80%

Identification of separate performance obligations .59 The engineering and construction industry is concerned that the proposed definition of a distinct performance obligation in the 2010 Exposure Draft might require contracts to be accounted for as numerous separate performance obligations, which might not reflect the substance of the contract. The 2011 Exposure Draft clarifies that promised goods or services are not distinct if they are highly interrelated and significantly customized. .60 Some concerns around identifying separate performance obligations remain, despite the industry generally being pleased with the clarifications made by the boards. The guidance indicates that every contract that contains a bundle of highly interrelated and significantly customized performance obligations must be a single performance obligation. This might often be the case, but there are situations when performance obligations are distinct yet also highly interrelated and significantly customized (for example, a contract with engineering, procurement, and construction services bundled together). Respondents recommend the boards revise the guidance to allow for the application of reasonable judgment in applying the principle to identify separate performance obligations. Uninstalled materials .61 Common in many engineering and construction contracts is the use of third parties, such as subcontractors to construct goods specifically for a project. These goods could remain uninstalled for a significant period of time, for example, due to long lead times to engineer, fabricate, and construct these items, or other factors. The proposed standard requires that an entity only recognize revenue to the extent of the cost of such uninstalled materials.

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.62 Respondents generally believe the profit recognized on goods specifically produced for the project should be consistent with the contract as a whole since contracts are typically bid with an overall profit margin in mind, not separate, distinct profit margins for different phases of the project. Transfer of materials customized specifically for a project represents progress towards satisfying the performance obligation. Respondents therefore propose that profit consistent with the overall contract be recognized on such uninstalled materials when measuring progress toward satisfying the performance obligation. Contract modifications .63 Contract modifications occur frequently in the engineering and construction industry. These modifications include changes to scope or price, including some that might be unapproved or in dispute (known as "claims"). Generally these modifications are approved after the contractor provides the related services. Respondents believe the proposed standard is unclear on the accounting for such modifications and recommend carrying forward existing guidance on the accounting for contract modifications for construction contracts. This existing guidance is similar under IFRS and U.S. GAAP and allows for recognition of amounts subject to claims or unapproved change orders in certain circumstances. PwC observation: The engineering and construction industry have expressed broad support for the boards' overall objectives; however, many in the industry (both preparers and users) do not believe the proposed model improves existing accounting. That said, the industry is generally satisfied with the direction of the 2011 Exposure Draft. Similar to the aerospace and defense industry, this industry has been active in working with the boards during the redeliberation process and, in fact, many of their concerns were addressed in the 2011 Exposure Draft. There is only a short list of concerns that remain and it is not surprising that these center on the nature of certain business practices in this industry. We believe the proposed revenue guidance could benefit from clarification in these areas.

Entertainment and media .64 The table below captures significant topics that remain top of mind for this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments

Transition Licenses Onerous test Disclosures 0% 20% 40% 60% 80% 100%

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Licenses .65 Some constituents have raised concerns over the accounting for perpetual licenses and time-based licenses, arguing that the two are economically different and therefore, should be accounted for differently. They believe revenue from perpetual licenses should be recognized when the license transfers and revenue from time-based licenses should be recognized over the relevant period. Others question this distinction, and highlight that it might be difficult to determine whether a license is perpetual or time-based if renewal options or cancellation clauses exist. .66 Many long term license arrangements for film and television contain licensorimposed restrictions. These may include interruptions on the right to use the license during the license term or constraints on the frequency and timing of the use of the license. For example, it is common for a licensor of an episodic television series to specify how the episodes should be sequenced, and with what frequency and over what time frame the episodes may be aired. Many respondents highlight that these complexities result in significant judgment to determine when control transfers. They believe additional clarity is needed to avoid inconsistent application of the guidance to such arrangements. .67 Digital distribution of licensed content has become more prevalent in the entertainment and media realm. A library or portfolio of content might be provided under a single arrangement; however, the content may be substituted or refreshed throughout the license term. Respondents question whether arrangements to distribute licensed intellectual property over certain digital platforms should be accounted for as a service arrangement satisfied over time, which many believe better reflects the economics of such transactions rather than a performance obligation satisfied at a point in time when the license is provided. Onerous performance obligations .68 The onerous test is likely to add significant complexity to the accounting within this industry. The boards have been asked to further clarify how to apply the onerous test when an entity pools its related programming costs. Programming assets are often recovered through cash flows from multiple distributor arrangements and advertising revenues. Respondents in the industry believe that when there is a pool of costs shared among several customer contracts, an onerous test applied at a level even higher than the contract would be more practical and better reflect the economic substance of these transactions. Some respondents also feel that the onerous test contradicts existing impairment guidance for these assets since loss recognition could occur even though the underlying program investment is profitable. PwC observation: Many constituents in the entertainment and media industry are concerned that the control-based criteria could result in immediate recognition of revenue from the licensing of intellectual property, which they believe contradicts the economic substance of certain arrangements. There are certain license arrangements, such as licenses of digital content or a portfolio of content, where revenue recognition over time might better reflect the benefit that the customer is receiving. Constituents feel that the standard should be flexible enough to account for the economic substance of different license arrangements, including reflecting revenue in the period of benefit to the customer. This issue is becoming more prevalent with the recent growth in digital distribution of media content. We believe significant judgment will be required in determining the application of the control-based criteria to these arrangements.

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Financial institutions .69 Financial services companies such as banking institutions, insurance companies, real estate, and asset managers commented on a variety of issues. However, the applicability of the reasonably assured constraint on performance fees is one of the main concerns highlighted by asset management entities. The customer loyalty program for credit cards is one of the main concerns highlighted by banks and other financial services entities. Asset management Reasonably assured constraint .70 Common revenue streams in scope of the proposed standard are performance fees, management fees, and upfront fees. Respondents are primarily concerned with the potential impact the proposed standard might have on performance fees. Performance fees are usually based on the value of investments managed by funds, subject to certain thresholds (for example, hurdle rate, high water mark or internal rate of return). Performance fees are often subject to clawback provisions requiring the return of a portion of the fees received if the cumulative performance results of the fund are lower than expected. This raises concerns as to when the fees should be considered reasonably assured. Revenues could be deferred in some cases if the payments are not reasonably assured until there is no risk of return, which could result in revenue being recognized well after the cash has been received. .71 Respondents are concerned that the overall usefulness of their financial statements will decline as a result of deferring revenue in such situations. Respondents believe the treatment of performance fees is well understood in the industry and recommend the boards conduct further industry outreach before issuing a final standard. PwC observation: The proposed standard might impact the timing of the recognition of performance fees as these fees may be highly susceptible to external factors such as market risk. Under current U.S. GAAP, asset managers can apply one of two methods to account for performance fees. We do not expect the proposed standard to significantly affect asset managers that currently recognize performance fees in the periods during which the related services are performed and all the contingencies have been resolved. On the other hand, asset managers that currently recognize performance fees using the hypothetical liquidation method will be impacted since under this approach revenue is typically recognized in advance of the amount becoming reasonably assured as defined under the proposed standard. Asset managers currently under IFRS will generally not be significantly impacted by the proposed standard as the majority of asset managers already recognize performance fees when the fee becomes reliably measurable, which is often at the end of the performance period when the outcome is known.

Financial services Customer loyalty programs .72 The banking and capital markets industry is concerned about whether credit card loyalty programs are in the scope of the proposed standard. A card issuer earns a processing fee from the merchant on the revenue transaction that occurs between the merchant and the cardholder in a typical credit card reward program. The cardholder earns reward points from the card issuer at the same time. Some respondents argue that

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these are two separate arrangements, one with the merchant for the processing fee and another with the cardholder for the reward program. .73 Respondents recommend that the boards clarify how to apply the proposed standard to these multiple party arrangements if they are in the scope of the standard. They also highlight that the example included in the proposed standard on customer loyalty programs is not applicable to credit card reward programs because the awards arise out of a transaction outside the scope of the revenue standard (that is, a financing arrangement). .74 Many respondents interpret the proposed guidance to mean credit card loyalty programs are outside the scope of the proposed guidance since the card issuer, the merchant and the cardholder are unrelated parties and there is no price interdependency among these contracts. .75 Respondents also have noted that the guidance on measuring the transaction price seems to provide an exception to the contract combination guidance. Consideration payable to a customer or to other parties that purchase the entity's goods or services is treated, in either case, as a reduction of the transaction price with the customer. Respondents therefore believe that additional clarity is needed to understand whether credit card reward programs are scoped into the proposed guidance. .76 Some respondents have suggested that accounting for credit card loyalty credits as performance obligations will introduce significant complexity to existing accounting. Many credit card issuers currently recognize the cost of loyalty rewards as an offset to merchant fee income when rewards are earned and record a corresponding liability. Respondents believe that applying the proposed guidance will require cash rewards to be netted against merchant fee income as a reduction of the transaction price, but non-cash rewards will result in only a deferral of recognition as the transaction price would remain the same. Respondents consider cash and non-cash rewards to be economically similar and believe they should not have different accounting treatments. PwC observation: The industry has been vocal both in roundtables and in comment letter responses that they do not believe that the proposed accounting is appropriate for credit card loyalty programs. There are concerns about the accounting for loyalty awards that are provided outside of a revenue transaction, such as upon opening a credit card account. We believe it is also unclear which revenue streams should be considered to determine the amount of revenue to be deferred. That is, whether it is payments made by the card holder to participate in the program, merchant fees, interest charged to the card holder, or some combination of the above. We agree it is unclear and that the boards need to provide greater clarity on the accounting for contracts that involve multiple parties.

Pharmaceutical, life sciences, and health care .77 Respondents from this industry commented on a variety of issues. The key areas focus on the definition of a customer and accounting for collaboration arrangements. Definition of a customer .78 The proposed standard defines a customer as the party contracted to receive output of an entity's ordinary activities. It further states that the counterparty in a contract might or might not be a customer, and lists a collaborator or partner as an example of
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this. Respondents from the industry are concerned that there can be arrangements in which the definition of a customer under the proposed standard is not clear. Respondents are looking for further guidance on how to account for these arrangements. Collaboration arrangements .79 Collaborative arrangements in the industry commonly focus on product development, but also include other activities such as distributing and marketing a product. The proposed standard only makes reference to collaboration agreements focused on product development. Respondents recommend broadening this to include other types of collaboration agreements that should be scoped out of the proposed standard. PwC observation: Certain collaboration arrangements in the biotechnology industry might be with parties that are not customers and therefore appear out of scope. Being a collaborator in an arrangement does not automatically mean the contract is scoped out of the revenue standard, as such contracts can have both revenue and non-revenue elements. Judgment will be needed to determine which elements of such arrangements should be accounted for under the revenue standard and which will be accounted for under other guidance.

Technology .80 The table below captures significant topics that remain a concern for this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments

Transition Disclosures Separate performance obligations Contract costs Onerous test 0% 10% 20% 30% 40% 50% 60% 70%

Identification of separate performance obligations .81 The identification of separate performance obligations continues to be an area of concern for the technology industry. Respondents' interpretation of the proposed standard suggest that even though bundled arrangements have components that meet the distinct criteria, the entity would have to account for the arrangement as a single performance obligation if the bundled goods or services are highly interrelated and customized. .82 It is common in the software industry to sell a license and related implementation and customization services separately. There is concern that the proposed guidance implies that if the entity is awarded the service with the license in the bidding process, this would be accounted for as a single performance obligation. In some situations, this
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results in revenue for the license being deferred and recognized in accordance with the transfer of control over time in combination with the implementation and customization services. This is a contrast to when the license and service are not awarded at the same time which would result in revenue for the license recognized upon transfer to the customer. Contract costs .83 A majority of respondents from the technology industry disagree with capitalizing incremental costs of obtaining a contract with a customer, such as sales commissions. Sales commissions are commonly based on a variety of measures such as overall contract performance or customer satisfaction and rarely are based solely on contract acquisitions. Respondents acknowledge the practical expedient, but believe the one year exclusion is arbitrary. They recommend allowing a policy election to avoid the operational burden of this guidance as they feel the benefit to users of financial statements is not significant. PwC observation: There were a number of software companies that responded to the 2011 Exposure Draft that still have concerns about accounting for software deliverables. The principles of the proposed standard will result in virtually all of the deliverables that are currently included in most software transactions (license, PCS, services, etc.) being accounted for separately. Software companies that recognize licenses and postcontract support ratably over the contractual term due to the inability to establish vendor-specific objective evidence will be required to separate the deliverables under the proposed guidance. As a result, revenue may be accelerated and some software companies are reluctant to abandon the ratable revenue recognition model in these cases. The proposed guidance could also require companies to defer more costs. Specifically, those companies that expense sales commissions as paid and set-up costs as incurred could now be required to capitalize and amortize these costs. Respondents believe the proposed guidance could be an operational burden for companies that currently expense all contract costs as incurred, except where the practical expedient applies.

Telecommunications .84 The table below captures significant topics commented on by this industry. We have summarized the more significant issues and concerns below. The percentages represent the percentage of responses within an industry group that commented on a specific topic. Summary of comments

Disclosures Allocation of transaction price Contract costs Transition 0% 10% 20% 30% 40% 50% 60% 70%

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.85 Telecom respondents have primarily focused on two key areas of concern: (i) the allocation of transaction price; and (ii) costs to obtain a contract. Allocation of transaction price .86 Wireless service providers typically offer highly subsidized handsets to customers signing up for a service plan. Standalone sales of wireless devices do occur but are typically limited to sales to third party resellers or dealers, or direct sales to customers replacing a lost or broken device. Telecommunication entities view neither instance as indicative of the selling price of devices if sold regularly on a standalone basis to customers. .87 The proposed guidance eliminates the contingent revenue cap that currently exists under U.S. GAAP and is regularly applied by the industry. That is, the amount allocated to a delivered item is limited to the amount that is not contingent upon the delivery of additional items or meeting other specified performance conditions (i.e., the noncontingent amount). Revenue allocated to the subsidized handset would be greater under the proposed standard, resulting in earlier revenue recognition. Respondents do not believe this represents the economic substance of these transactions, as the industry focuses on the service aspect of these transactions as opposed to the sale of the handsets. .88 As proposed in the standard, using the residual approach is limited to situations where the standalone selling price of a good or service is highly variable or uncertain. Some respondents propose to expand the scope of the residual approach to also include goods or services sold infrequently on a standalone basis. Others propose refinements to the guidance on allocating a discount to specific performance obligations, which they believe better reflects the economics of selling deeply discounted handsets to customers. Contract costs .89 Respondents generally oppose the requirement to capitalize incremental costs of obtaining a contract. They note that capitalizing sales commissions will require significant estimation and periodic impairment evaluations that would introduce judgment and variability to an otherwise uncomplicated process. Respondents propose removing the requirement to account for costs to obtain a contract from the proposed standard or allow constituents to have a policy election for immediate recognition of expense. PwC observation: The telecommunications industry has been one of the most vocal in providing feedback to the boards, both in public and private roundtables, comment letters, and other communications. The industry vehemently disagrees with the allocation of revenue to the mobile phone handsets in an amount that exceeds cash received, as they feel this does not represent the economics of their business. They also contend that the costs to change systems and processes will be significant. We understand the concerns of the industry and the practical challenges of implementation, but believe that any proposed solution needs to be consistent with the principles in the model so as to avoid unintended consequences to other industries.

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Next steps
.90 The boards will begin to redeliberate the proposed standard in June 2012. We have included the proposed redeliberation timeline in Appendix B, which details the expected timing of discussion of outstanding issues by the boards.

Questions
.91 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group (1-973-236-4377 or 1-973-236-7804).

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Appendix A Summary of significant comment letter topics by industry group

Topics
Performance obligations satisfied over time Presentation of the effects of credit risk Recognition of variable consideration Onerous test Disclosures Transfer of non-financial assets Time value of money Transition Identification of separate performance obligations Allocation of transaction price Contract costs Consideration payable to a customer Repurchase agreements

Aerospace & defense

Automotive

Consumer industrial products

Engineering & construction

Entertainment & media

Financial institutions

Pharma, life sciences, & health care

Technology

Telecom

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Appendix B Proposed project timeline1

Month June 2012

Topic Identification of separate performance obligations (Step 2) Satisfaction of performance obligations (Step 5) Contract issues (Step 1)

July 2012 Licenses Onerous test Constraint (Step 5) September 2012 Collectibility Time value of money (Step 3) Scope Costs October 2012 Allocation of the transaction price (Step 4) Nonfinancial assets Disclosures November 2012 Transition, effective date & early adoption Sweep issues & consequential amendments December 2012 Cost-benefit analysis Q1 2013 Q2 2013 & Thereafter Publication Post-publication 6 5 4 3 2

Excerpted from page 21 of the Staff Paper, Revenue recognition Project plan for redeliberations, discussed at the May 21-25, 2012 public meeting of the FASB and IASB. The Staff Paper is copyrighted by the Financial Accounting Foundation and the IFRS Foundation, and this excerpt has been reproduced with permission. The Staff Paper was prepared by the staff of the FASB and IFRS Foundation for discussion at the public meeting. It does not purport to represent the views of any individual members of either board. Comments on the application of US GAAP or IFRSs do not purport to set out acceptable or unacceptable application of US GAAP or IFRSs. The FASB and the IASB report their decisions made at public meetings in FASB Action Alert or in IASB Update.
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2011 ED Question 1

Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Jennifer Chen Senior Manager Phone: 1-973-236-4735 Email: jennifer.y.chen@us.pwc.com Anurag Saha Senior Manager Phone: 1-973-236-5038 Email: anurag.saha@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives. 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Dataline A look at current financial reporting issues


Revenue from contracts with customers The proposed revenue standard is re-exposed
Overview
At a glance The FASB and IASB (the "boards") released an updated exposure draft, Revenue from Contract with Customers, on November 14, 2011 and are requesting comments by March 13, 2012. The boards have asked whether the proposed guidance is clear, and requested feedback specifically on: performance obligations satisfied over time; presentation of the effects of credit risk; recognition of variable consideration; the scope of the onerous performance obligation test; interim disclosures; and transfer of nonfinancial assets that are outside an entity's ordinary activities (for example, sale of PP&E). The proposed model requires a five-step approach. Management will first identify the contract(s) with the customer and separate performance obligations within the contract(s). Management will then estimate and allocate the transaction price to each separate performance obligation. Revenue is recognized when an entity satisfies its obligations by transferring control of a good or service to a customer. It is unclear when a final standard will be issued; however, the boards have indicated that the final standard will have an effective date no earlier than 2015. Full retrospective application will be required with the option to apply limited transition reliefs. Background .1 The boards initiated this joint project in 2002 to develop a common revenue standard for U.S. GAAP and IFRS. The original exposure draft was issued in June 2010 (the "2010 Exposure Draft"). .2 The boards received nearly 1,000 comment letters on the 2010 Exposure Draft, which highlighted a number of recurring themes that were discussed during re_____________

No. 2011-35 November 22, 2011


(Revised January 3, 2012*)

Whats inside: Overview .......................... 1


At a glance ...............................1 Background .............................1 Scope ....................................... 2

The proposed model ........3


Identify the contract with the customer ................ 3 Identify the separate performance obligations ..... 5 Determine the transaction price and amounts not expected to be collected ........ 7 Allocate the transaction price to distinct performance obligations .... 11 Recognize revenue when (or as) each performance obligation is satisfied ............................12

Other considerations..... 17 Disclosures .....................25 Transition ..................... 26 Next steps ....................... 27 Questions ....................... 27 Appendix Key differences between the 2010 and 2011 exposure drafts .......................... 28

* Example 7.1 in the subsection Measurement of progress was revised to correct the calculation of "rev enue
recognized to date" by excluding the correct amount of costs related to uninstalled materials.
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deliberations. They addressed several areas including the identification of separate performance obligations, determining the transaction price, accounting for variable consideration, transfer of control, warranties, contract costs, and accounting for licenses to use intellectual property, among others. .3 The boards decided to re-expose the proposed revenue guidance to avoid unintended consequences from the final standard and to increase transparency. The updated exposure draft was issued in November 2011. References within this Dataline to the exposure draft or proposed standard refer to the exposure draft issued in November 2011, unless otherwise indicated. .4 The exposure draft proposes a new revenue recognition model that could significantly change the way entities recognize revenue. The objective is to remove inconsistencies in existing revenue requirements and improve the comparability of revenue recognition across industries and capital markets. .5 The proposed standard employs an asset and liability approachthe cornerstone of the FASBs and IASBs conceptual frameworks. Current revenue guidance under both frameworks focuses on an earnings process, but difficulties often arise in determining when revenue is "earned" and when the earnings process is complete. The boards believe a single, contract-based model that reflects changes in contract assets and liabilities will lead to greater consistency in the recognition and presentation of revenue. PwC observation: The proposed standard will be a significant shift in how revenue is recognized in many circumstances. The effect could be considerable, requiring management to perform a comprehensive review of existing contracts, business models, company practices, and accounting policies. The proposed standard could also have broad implications for an entity's processes and controls. Management might need to change existing IT systems and internal controls in order to capture different information than in the past. The effect could extend to other functions such as treasury, tax, and human resources. For example, changes in the timing or amount of revenue recognized may affect long-term compensation arrangements, debt covenants, and key financial ratios. .6 This Dataline explores key aspects of the proposed standard. The boards' conclusions are tentative and subject to change until they issue the final standard. We have summarized the key changes to the 2010 Exposure Draft in an Appendix to this Dataline. Scope .7 The proposed standard defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied by an entity's customary business practice. A customer is defined as a party that has contracted with an entity to obtain goods or services that are an output of the entity's ordinary activities. .8 The proposed standard applies to an entity's contracts with customers, except for: Lease contracts Insurance contracts Certain contractual rights or obligations within the scope of other standards including financial instruments and extinguishments of liabilities

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Certain guarantees within the scope of other standards (other than product warranties) Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers .9 Some contracts might include components that are in the scope of the proposed standard and other components that are in the scope of other standards (for example, a contract that includes both a lease and maintenance services). In this situation, an entity will apply the other standard to separate and measure that component of the contract if that standard has separation and measurement guidance. Otherwise, the principles of this proposed standard are applied. PwC observation: The proposed standard addresses contracts with customers across all industries and eliminates industry-specific guidance. Most transactions accounted for under existing revenue standards in U.S. GAAP and IFRS will be within the scope of the proposed standard. Certain transactions in industries that recognize revenue from a counterparty that is a collaborator or partner that shares risk in developing a product might not be in the scope of the proposed standard. For example, some collaborative arrangements in the biotechnological industry or entitlement-based arrangements in the oil and gas industry might not be within the scope of the proposed standard.

The proposed model


.10 Entities will perform the following five steps in applying the proposed model: Identify the contract with the customer Identify the separate performance obligations in the contract Determine the transaction price and amounts not expected to be collected Allocate the transaction price to separate performance obligations Recognize revenue when (or as) each performance obligation is satisfied PwC observation: The steps in the proposed standard may appear simple, but significant judgment will be needed to apply the principles. For example, determining whether a good or service is a separate performance obligation, and thus should be accounted for separately, will require judgment. Management will also need to consider a number of factors to estimate the transaction price, including the effects of variable consideration and time value of money.

Identify the contract with the customer .11 A contract exists if all the following criteria are met: The contract has commercial substance

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The parties to the contract have approved the contract and are committed to perform their respective obligations Management can identify each party's rights and obligations regarding the goods or services to be transferred Management can identify the terms and manner of payment for the goods or services to be transferred .12 Two or more contracts entered into at or near the same time with the same customer (or parties related to the customer) may need to be combined if one or more of the following criteria are met: The contracts are negotiated with a single commercial objective The consideration paid in one contract depends on the price or performance under the other contract The goods or services promised under the contracts are a single performance obligation PwC observation: Identifying the contract with the customer will be straightforward in many cases. The approval of a contract might not be as strict as some existing guidance under U.S. GAAP. For example, the software guidance under U.S. GAAP today has strict rules to establish whether or not a contract with the customer meets the evidence of an arrangement requirement. The underlying concepts are otherwise consistent with existing guidance under U.S. GAAP and IFRS. It may be more challenging to identify the contract with the customer in situations where an arrangement involves three or more parties, particularly if there are separate contracts with each of the parties. These types of arrangements might occur in the asset management industry, for example, or when credit card holders buy goods from a retailer but receive reward points from the credit card issuer. The exposure draft does not include specific guidance on how to account for these types of arrangements. .13 A contract modification is treated as a separate contract only if it results in the addition of a separate performance obligation and the price reflects the stand-alone selling price (that is, the price the good or service would be sold for if sold on a standalone basis) of the additional performance obligation. The modification is otherwise accounted for as an adjustment to the original contract either through a cumulative catch-up adjustment to revenue or a prospective adjustment to revenue when future performance obligations are satisfied, depending on the facts and circumstances. Example 1.1 Contract modifications: A manufacturing entity enters into a contract with a customer to deliver 1,000 products over a one year period for $50 per product. The products are distinct performance obligations because the entity regularly sells each product separately (see paragraphs 14-19). The contract is modified six months after inception to include an additional 500 products for $45 per product. The new price reflects the stand-alone selling price of the product at the time of the contract modification.

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The contract modification is a separate contract that should be accounted for prospectively. The additional products are distinct performance obligations and the price reflects the stand-alone selling price of each product at the time of the contract modification. Example 1.2 Contract modifications: A construction entity enters into a contract with a customer to build a customized house. The contract is a single performance obligation given the deliverable promised to the customer (see paragraphs 14-19). Costs incurred to date in relation to total estimated costs to be incurred is the best measure of the pattern of transfer to the customer (see paragraphs 39-40). The original transaction price in the contract was $500,000 with estimated costs of $400,000. The customer requests changes to the design midway through construction ($200,000 of costs have been incurred). The modification increases the transaction price and estimated costs by $100,000 and $50,000, respectively. The entity should account for the contract modification as if it were part of the original contract because the modification does not result in a separate performance obligation. Management should update its measurement of progress on the original contract to reflect the contract modification because the remaining goods and services are part of a single performance obligation that is partially satisfied at the modification date.
Original Transaction price Estimated costs Percent complete Revenue to date Incremental revenue $500,000 $400,000 50% $250,000 Modification $100,000 $50,000 Revised $600,000 $450,000 44% $264,000 $14,000

Identify the separate performance obligations .14 A performance obligation is a promise (whether explicit, implicit or implied) in a contract with a customer to transfer a good or service to the customer. A contract might explicitly state performance obligations, but they could also arise in other ways. Legal or statutory requirements can create performance obligations even though such obligations are not explicit in the contract. Customary business practices, such as an entity's practice of providing customer support, might also create performance obligations. .15 An entity accounts for each promised good or service as a separate performance obligation if the good or service is distinct. A good or service is distinct if either of the following criteria is met: 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

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.16 An entity shall combine a bundle of distinct goods or services into a single performance obligation if both of the following criteria are met: The goods or services are highly interrelated and require the entity to provide a significant service of integrating the goods or services into a combined item that the customer has contracted for The entity significantly modifies or customizes the goods or services to fulfill the contract .17 Readily available resources are goods or services that are sold separately by the entity or another entity, or resources that the customer already has obtained from the entity or from other transactions or events. .18 An entity may account for separate performance obligations satisfied at the same time or over the same period as one performance obligation as a practical expedient. .19 An entity should combine goods or services that are not distinct with other goods or services until there are bundles of goods or services that are distinct. PwC observation: The exposure draft provides criteria for assessing whether a bundle of goods or services should be combined into a single performance obligation, but does not provide detailed guidance on how to assess whether integration services are "significant" or when an entity is "significantly" modifying or customizing a good. We believe management should carefully evaluate the criteria provided to ensure that combining goods and services results in accounting that reflects the underlying economics of the transaction. Example 2.1 Integration services: A construction entity enters into a contract with a customer to build a bridge. The entity is responsible for the overall management of the project including excavation, engineering, procurement, and construction. The entity would account for the bundle of goods and services as a single performance obligation since the goods and services to be delivered under the contract are highly interrelated. There is also a significant integration service to customize and modify the goods and services necessary to construct the bridge. Example 2.2 Separate performance obligations and consideration of timing: A manufacturing entity enters into a contract with a customer to sell a unique tool and replacement parts. The entity always sells the unique tool and replacement parts together, and no other entity sells either product. The customer can use the unique tool without the replacement parts, but the replacement parts have no use without the unique tool. There would be two distinct performance obligations if the manufacturing entity transfers the tool first, because the customer can benefit from the tool on its own and the customer can benefit from the replacement parts using a resource that is readily available (that is, the tool that was transferred first).
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There would only be one performance obligation if the manufacturing entity transfers the replacement parts first, because the customer does not have a readily available resource to benefit from the replacement parts. The entity would account for both products as a single performance obligation in this scenario.

Determine the transaction price and amounts not expected to be collected .20 The transaction price in a contract reflects the amount of consideration that an entity expects to be entitled to in exchange for goods or services delivered. The transaction price is readily determinable in some contracts because the customer promises to pay a fixed amount of consideration in return for the transfer of a fixed number of goods or services in a reasonably short timeframe. In other contracts, management needs to consider the effects of: Variable consideration Time value of money Noncash consideration Consideration paid to a customer Variable consideration .21 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, refunds, credits, incentives, performance bonuses, and royalties. Management estimates the total amount of consideration the entity is entitled to as part of the transaction price when a contract includes variable consideration. Management should use one of the following approaches to estimate variable consideration depending on which is the most predictive, and that estimate should be updated at each reporting period: The expected value, being the sum of probability-weighted amounts The most likely outcome, being the most likely amount in a range of possible amounts .22 The amount of variable consideration included in the transaction price and allocated to a satisfied performance obligation should be recognized as revenue only when the entity is reasonably assured to be entitled to that amount. See paragraphs 41-43 for further discussion of this constraint on the recognition of revenue. PwC observation: The proposed guidance requires management to determine the total transaction price, including an estimate of variable consideration, at the outset of the contract and on an ongoing basis. Variable consideration is also referred to as contingent consideration and can come in a variety of forms. Some contingencies may relate to future performance by the seller that is substantially within the seller's control, while other contingencies may depend heavily on the actions of a customer or a third party.

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Dataline

Revenue will not be recognized for variable consideration if the entity is not reasonably assured to be entitled to that consideration, as discussed further below. However, management may still be required to estimate all forms of variable consideration to measure and allocate the transaction price to each separate performance obligation. In some cases, such as when there is only a single performance obligation that is delivered at a point in time, it may not be necessary to estimate variable consideration until management is reasonably assured to be entitled to the consideration. Example 3.1 Estimating variable consideration: A construction entity enters into a contract with a customer to build an asset for $100,000 with a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance bonus decreases by 10 percent per week for every week beyond the agreed-upon completion date. The contract requirements are similar to contracts the entity has performed previously and management believes that such experience is predictive for this contract. Management estimates that there is a 60% probability that the contract will be completed by the agreed-upon completion date, a 30% probability that it will be completed one week late, and only a 10% possibility that it will be completed two weeks late. The transaction price should include managements estimate of the amount of consideration to which the entity will be entitled. Management has concluded that the probability-weighted method is the most predictive approach for estimating the variable consideration in this situation:
60% chance of $150,000=$90,000 30% chance of $145,000=$43,500 10% chance of $140,000=$14,000

The total transaction price would be $147,500 based on the probability-weighted estimate. Management should update its estimate each reporting date. Using a most likely outcome approach may be more predictive if a performance bonus is binary such that the entity earns either $50,000 for completion on the agreed-upon date, or nothing for completion after the agreed-upon date. In this scenario, if management believes that the entity will meet the deadline and estimates the consideration using the most likely outcome, the total transaction price would be $150,000.

Time value of money .23 The transaction price should reflect the time value of money when the contract contains a significant financing component. When a significant financing component exists, management should use a discount rate that reflects a financing transaction between the entity and its customer that does not involve the provision of other goods or services. The entity presents the effects of financing as interest expense or income. .24 Management should consider the following factors to determine if there is a significant financing component in a contract: The length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services
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Whether the amount of consideration would substantially differ if the customer paid in cash at the time of transfer of the goods or services The interest rate in the contract and prevailing interest rates in the relevant market .25 An entity is not required to reflect the time value of money in the measurement of the transaction price when the time from transfer of the goods or services to payment is less than one year, as a practical expedient. PwC observation: Determining whether a significant financing component exists in a contract could be particularly challenging in long-term or multiple-element arrangements where goods or services are delivered and cash payments are made throughout the arrangement. Management will need to assess the timing of delivery of goods and services in relation to cash payments to determine if the length of time is in excess of one year, which could indicate that a significant financing component exists. Accounting for the effects of the time value of money could result in a considerable change in practice for certain entities, particularly when consideration is paid significantly in advance or in arrears. This could result in the recognition of revenue in an amount that is different from the amount of cash received from the customer. If payments are made in arrears, revenue recognized will be less than cash received. If payments are made in advance, revenue recognized will exceed the cash received. An example of how to apply the guidance for the time value of money in a basic transaction is included in the implementation guidance within the proposed standard. The calculations could be significantly more challenging in complex situations or when estimates change throughout the life of an arrangement.

Noncash consideration .26 An entity measures noncash consideration received for satisfying a performance obligation at its fair value. When management cannot estimate fair value reliably, the entity measures the noncash consideration received indirectly by reference to the standalone selling price of the goods or services transferred. Consideration paid to a customer .27 Consideration paid by an entity to its customer might include rebates or upfront payments (for example, slotting fees), and could take the form of cash or credit. Consideration paid to a customer is assessed to determine if the amount should be reflected as a reduction of the transaction price, because it represents a discount on the goods or services delivered or to be delivered. If the consideration represents payment for distinct goods or services received from the customer, it is treated like any other purchase from a vendor. .28 An entity reduces revenue when it pays consideration to a customer that represents a discount at the later of when the entity: (a) transfers the promised goods or services to the customer or (b) promises to pay the consideration (even if the payment is conditional on a future event). That promise may be implied by customary business practice.

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PwC observation: The underlying concepts for both noncash consideration and consideration paid to a customer are consistent with current revenue guidance under both U.S. GAAP and IFRS. We do not anticipate a significant change in practice in these areas on adoption of the proposed standard. The proposed guidance is not as explicit about whether payments paid to customers to enter into a customer-vendor relationship should be capitalized. We believe that in certain situations these amounts should be capitalized and the subsequent amortization of such amounts would reduce revenue.

Collectibility .29 Collectibility refers to the risk that the customer will not pay the promised consideration. An entity recognizes an allowance for any expected impairment loss (determined in accordance with ASC 310, Receivables, or IFRS 9, Financial Instruments) and presents that allowance in a separate line item adjacent to revenue. Both the initial assessment and any subsequent changes in the estimate are recorded in this line item (if the contract does not have a significant financing component). PwC observation: Current guidance requires that revenue cannot be recognized unless collectibility is reasonably assured (under U.S. GAAP) or is probable (under IFRS). Collectibility will no longer be a recognition threshold, so revenue might be recognized earlier under the proposed guidance. Presenting credit risk in this manner will align revenue recognized with cash ultimately received from the customer if the contract does not have a significant financing component. This will help financial statement users who are interested in reconciling revenue with cash ultimately received from the customer. It is not clear where impairment will be classified if the arrangement contains a significant financing component. The proposed guidance requires management to look to ASC 310 or IFRS 9 to measure expected impairment loss. We believe there is a potential conflict with the impairment model in ASC 310 and IFRS 9 in the classification of subsequent changes to the initial assessment. Subsequent impairment of a financial instrument is recognized as other income and expense, while subsequent changes for receivables would be recognized in the line item adjacent to revenue. The boards have acknowledged that this decision could create consequences for the impairment model being developed for financial instruments and it will therefore need to be discussed further at a future date. Example 4.1 Presentation of credit risk: A consumer products entity enters into a contract with a customer to provide goods for $1,000. Payment is due one month after the goods are transferred to the customer. Management assesses that the customer will not pay 10% of the consideration based on its current knowledge of the customer and its financial position. The entity should recognize revenue, which reflects the total transaction price under the contract, when the goods are transferred to the customer. The entity would also

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recognize the estimated amount of consideration that is uncollectible as a separate line item adjacent to the revenue line item. The below table summarizes the presentation under the current and proposed guidance.
Current Revenue $1,000 Proposed Revenue Impairment loss Subtotal COGS GM $ GM % (400) 600 60% COGS GM $ GM % $1,000 (100) 900 (400) 500 56%

Allocate the transaction price to distinct performance obligations .30 The transaction price should be allocated to separate performance obligations in a contract based on the relative stand-alone selling prices of the goods or services. The best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately. Management needs to estimate the selling price if a stand-alone selling price is not available, and should maximize the use of observable inputs. Possible estimation methods include (but are not limited to): Expected cost plus reasonable margin Assessment of market prices for similar goods or services Residual approach, in certain circumstances .31 A residual approach may be used to calculate the stand-alone selling price when there is significant variability or uncertainty in one or more performance obligations, regardless of whether that performance obligation is delivered at the beginning or end of the contract. A residual approach involves estimating the stand-alone selling price of a good or service by reference to the total transaction price less the sum of the stand-alone selling prices of other goods or services promised in the contract. .32 A selling price is highly variable when an entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when an entity has not yet established a price for a good or service or the good or service has not previously been sold. .33 An entity should allocate a discount entirely to one separate performance obligation in the contract if the price of a good or service is largely independent of the price of other goods or services in the arrangement based on the following criteria: The entity regularly sells each good or service in the contract separately The observable selling prices from those sales provide evidence of the performance obligation to which the entire discount in the contract belongs .34 Changes to the transaction price, including changes in the estimate of variable consideration, might only affect one performance obligation. Such changes would be allocated to that performance obligation rather than all performance obligations in the arrangement if the following criteria are met:

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The contingent payment terms relate to a specific performance obligation or outcome from satisfying that performance obligation Allocating the contingent amount of consideration entirely to the separate performance obligation is consistent with the amount of consideration that the entity expects to be entitled for that performance obligation PwC observation: The residual approach in the proposed guidance should not be confused with the residual method that has historically been used to allocate the transaction price by software companies applying U.S. GAAP and, in some circumstances, by companies under IFRS. First, the proposed guidance states that the residual approach should only be used when the standalone selling price of a good or service is highly variable or uncertain. Second, the residual approach would be used solely to develop an estimate of the stand-alone selling price of the separate good or service and not to determine the allocation of consideration to a specific performance obligation. Example 5.1 Use of residual approach: An entity enters into a contract with a customer to provide a package of products for $1,000. The arrangement includes three separate performance obligations: products A, B, and C. The entity sells products A and B both individually and bundled together in a package. Product C is unique and has never been sold before. Its estimated selling price is therefore unknown. Products A and B sell for $200 and $300, respectively, when sold on a stand-alone basis. However, as a package, products A and B sell for a discounted amount of $400. Management might conclude the estimated stand-alone selling price of product C is $600 ($1,000 less $400). The $1,000 transaction price would be allocated as follows:
Product A = ($200/$500) x ($400/$1,000) or 16% Product B = ($300/$500) x ($400/$1,000) or 24% Product C = $600/$1,000 or 60%

We believe this is one way that a residual approach might be used to estimate the stand-alone selling price. However, this concept is not illustrated in the proposed guidance and it is possible that this topic may be subject to further clarification by the boards.

Recognize revenue when (or as) each performance obligation is satisfied Transfer of control .35 Revenue is recognized when (or as) a promised good or service is transferred to the customer. An entity transfers a promised good or service and satisfies a performance obligation when the customer obtains control of that good or service. A customer obtains control of a good or service if it has the ability to direct the use of and receive the benefit from the good and service. Indicators that the customer has obtained control of the good or service include: The entity has a right to payment for the asset The entity transferred legal title to the asset

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The entity transferred physical possession of the asset The customer has the significant risk and rewards of ownership The customer has accepted the asset PwC observation: The proposed guidance provides indicators to determine the point of time at which a performance obligation is satisfied. The indicators are not a checklist, and no one indicator is determinative. The indicators are factors that are often present when control has transferred to a customer. There may be situations where some indicators are not met, but managements judgment is that control has been transferred. Management will still need to consider all of the facts and circumstances to understand if the customer has the ability to direct the use of and benefit from the goods or services.

Satisfaction of performance obligations over time .36 Performance obligations can be satisfied either at a point in time or over time. An entity transfers control of a good or service over time if at least one of the following two criteria is met: The entity's performance creates or enhances an asset that the customer controls The entity's performance does not create an asset with alternative use to the entity and at least one of the following criteria is met:

The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially re-perform the work the entity has completed to date if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fufill the contract

.37 An asset with alternative use is an asset that an entity could readily direct to another customer. For example, a standard inventory item might have an alternative use because it can be used as a substitute across multiple contracts with customers. An asset that is highly customized would be less likely to have an alternative use to the entity because the entity would likely incur significant costs to direct the asset to another customer. .38 Management should consider the effects of contractual limitations when assessing whether an asset has an alternative use. A contract that precludes an entity from redirecting an asset to another customer results in the asset not having an alternative use because the entity is legally obligated to direct the asset to a specific customer. PwC observation: Management will need to apply judgment to assess the criteria for when a performance obligation is satisfied over time to ensure the timing of revenue recognition reflects the transfer of control to the customer based on the economic substance of the arrangement.

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We understand the objective of the right to payment criterion is that the consideration would be intended to compensate the entity for performance to date and not, for example, a stipulated penalty to cover lost profits in the arrangement. Example 6.1 Assessing whether an asset has alternative use: An industrial products entity enters into a contract with a customer to deliver the next piece of specialized equipment produced. The customer paid a deposit that is only refundable if the entity fails to perform. The deposit also requires the entity to procure materials to produce the specialized equipment. The contract precludes the industrial products entity from redirecting the piece of specialized equipment to another customer. The specialized equipment does not have alternative use to the industrial products entity because the contract has substantive terms that preclude the entity from redirecting the specialized equipment to another customer. The industrial products entity would need to assess the rest of the criteria to determine if production of the specialized equipment represents a performance obligation satisfied over time. The performance obligation would be satisfied at a point in time if the criteria are not met. In this example, it is likely that the performance to date would have to be reperformed by another entity and the customer doesnt immediately receive the benefits of the entitys performance. Therefore, management would have to assess whether the deposit is a right to payment that is commensurate with work performed. If not, and assuming the other criteria are not met, the performance obligation would be satisfied at a point in time, not over time.

Measurement of progress .39 An entity recognizes revenue for a performance obligation satisfied over time by measuring the progress toward complete satisfaction of the performance obligation. The objective when measuring progress is to depict the transfer of control of the promised goods or services to the customer. Methods for measuring progress include: Output methods that recognize revenue on the basis of units produced, units delivered, contract milestones, or surveys of work performed Input methods that recognize revenue on the basis of costs incurred, labor hours expended, time lapsed, or machine hours used .40 When applying an input method to a separate performance obligation that includes goods that a customer controls at a point in time significantly prior to the performance of the services related to those goods, revenue may be recognized in an amount equal to the cost for those goods if both conditions are present: The cost of the transferred goods is significant relative to the total expected costs to completely satisfy the performance obligation The entity procures the goods from another entity and is not significantly involved in designing and manufacturing the goods

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PwC observation: The exposure draft allows both input and output methods for measuring progress, but management should select the method that best depicts the transfer of control of goods and services. Output methods directly measure the value of the goods or services transferred to the customer. The use of an input method measures progress toward satisfying a performance obligation indirectly. Management should take care when using an input model that the inputs represent the transfer of control of the asset to the customer and exclude any inputs that do not depict the transfer of control (for example, upfront purchases of significant materials that have not yet been utilized or transferred to the customer, or wasted effort or materials). Example 7.1 Use of an input method to measure progress: A manufacturing entity enters into a contract with a customer to provide specialized equipment and install the equipment into a data center facility. The entity will need to procure the specialized equipment from an independent source. The entity will account for the bundle of goods and services as a single performance obligation since the goods and services provided under the contract are highly interrelated. There is also a significant integration service to customize and modify the specialized equipment for the data center facility. The entity expects to incur the following cost in connection with the project:
Transaction price Cost of specialized equipment Other costs to fulfill Total estimated costs to complete $500,000 150,000 100,000 $250,000

The manufacturing entity concludes that an input method (costs incurred to date in relation to total estimated costs to be incurred) best depicts the pattern of transfer of control to the customer. Since the costs incurred by the entity to procure the specialized equipment are significant to the overall costs of the project and the entity is not involved in the manufacturing of the equipment, the entity excludes the costs of the equipment from its measurement of progress toward satisfaction of the performance obligation. The entity incurs the following costs and estimates progress for revenue recognition excluding the costs to procure the specialized equipment:
Incurred costs to date Cost of specialized equipment Other costs to fulfill Percent complete excluding specialized equipment ($50,000 / ($250,000 - $150,000)) Revenue recognized to date (50% x ($500,000 - $150,000))

150,000 50,000

50% $175,000

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The manufacturing entity estimates that the performance on the project is 50% complete and recognizes revenue of $175,000. The entity will recognize revenue in an amount equal to the costs of $150,000 upon transfer of control of the specialized equipment to the customer.

Constraint on revenue recognition .41 Variable consideration included in the transaction price that is allocated to a satisfied performance obligation is recognized as revenue only when the entity is reasonably assured to be entitled to that amount. An entity is reasonably assured when the entity has experience with similar types of contracts and that experience is predictive of the outcome of the contract. .42 Management needs to apply judgment to assess whether it has predictive experience about the outcome of a contract. The following indicators might suggest the entity's experience is not predictive of the outcome of a contract: The amount of consideration is highly susceptible to factors outside the influence of the entity The uncertainty about the amount of consideration is not expected to be resolved for a long period of time The entity's experience with similar types of contracts is limited The contract has a large number and broad range of possible consideration amounts .43 The proposed guidance includes an exception for intellectual property licensed in exchange for royalties based on the customer's subsequent sales of a good or service. The entity can only become reasonably assured to be entitled to the related variable consideration (the royalty payment) once those future sales occur. PwC observation: The boards included the reasonably assured constraint in response to feedback that revenue could be recognized prematurely for variable consideration. The constraint is not meant to be a specific quantitative threshold but rather a qualitative assessment based on the level of predictive experience held by a particular entity. We expect that some entities will recognize revenue earlier under the proposed guidance because they will be able to recognize amounts before all contingencies are resolved. The constraint on revenue recognition is generally limited to situations where management has no predictive experience. Revenue will be recognized in these circumstances only when the amounts become reasonably assured, which may be closer to the timing of recognition under existing practice. The "bright line" exception included in the proposed guidance for royalties received from licenses to use intellectual property seems to result in divergent outcomes for economically similar transactions in some cases. For example, the exposure draft includes an example (Example 14) that addresses trailing commissions received by an agent of an insurance company. The example concludes that the entity can recognize commissions related to future policy renewals at the outset of the arrangement because management determines such amounts are reasonably assured of being

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received. It is worth noting that like the royalties, the trailing commissions are also dependent on the customer's future sales. Therefore, the exposure draft appears to require that the exception for licenses to use intellectual property should not be applied by analogy to other types of transactions. Example 8.1 Estimating variable consideration based on predictive experience: An entity sells maintenance contracts to customers on behalf of a manufacturer for an upfront commission of $100 and $10 per year for each contract based on how long the customer renews the maintenance contract. Once the initial maintenance contracts have been sold, the entity has no remaining performance obligations. Management has determined that past experience is predictive (for example, experience with similar types of contracts and customers) and that experience indicates that customers typically renew for 2 years. The total transaction price is therefore estimated to be $120 and the entity will recognize that amount of revenue when the maintenance contract is sold to the customer. As renewal experience changes, management will update the transaction price and recognize revenue or a reduction of revenue to reflect the updated renewal experience.

Other considerations
Identify the separate performance obligations .44 The proposed standard includes guidance on the following areas when considering the impact of identifying separate performance obligations in the contract: Principal versus agent Options to acquire additional goods or services Licenses Rights of return Warranties Nonrefundable upfront fees Principal versus agent .45 Entities often involve third parties when providing goods and services to their customers. In these situations, management needs to assess whether the entity is acting as the principal or as an agent. An entity recognizes revenue gross if it is the principal, and net (that is, equal to the commission received) if it is an agent. An entity is the principal if it obtains control of the goods or services of another party in advance of transferring control of those goods or services to the customer. The entity is an agent if its performance obligation is to arrange for another party to provide the goods or services.

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.46 Indicators that the entity is an agent include: The other party has primary responsibility for fulfillment of the contract (that is, the other party is the primary obligor) The entity does not have inventory risk The entity does not have latitude in establishing prices The entity does not have customer credit risk The entity's consideration is in the form of a commission PwC observation: The proposed guidance and list of indicators are similar to the current guidance under U.S. GAAP and IFRS. The proposed guidance does not weigh any of the indicators more heavily than others. The growth in business models that involve the use of the internet to conduct transactions has continued to increase the focus in this area under existing standards. We expect similar issues to arise under the new guidance, but do not expect a significant change in practice in this area.

Options to acquire additional goods or services .47 An entity may grant a customer the option to acquire additional goods or services free of charge or at a discount. These options may include customer award credits or other sales incentives and discounts. That promise gives rise to a separate performance obligation if the option provides a material right to the customer that the customer would not receive without entering into the contract. The entity should recognize revenue allocated to the option when the option expires or when the additional goods or services are transferred to the customer. .48 An example of a material right would be a discount that is incremental to the range of discounts typically given to similar customers in the same market. The customer is effectively paying in advance for future goods or services and therefore, revenue is recognized when those future goods or services are transferred or when the option expires. .49 An option to acquire an additional good or service at a price that is within the range of prices typically charged for those goods or services does not provide a material right to the customer and is a marketing offer. This is the case even if the option can be exercised only because of entering into the previous contract. .50 The estimate of a stand-alone selling price for a customer's option to acquire additional goods or services is the discount the customer will obtain when exercising the option. This estimate is adjusted for any discount the customer would receive without exercising the option and the likelihood that the customer will exercise the option (that is, breakage or forfeiture). PwC observation: Under the proposed standard, the amount allocated to the loyalty rewards is deferred and revenue is recognized when the rewards expire or are redeemed. Under IFRS, an existing interpretation requires companies to account for loyalty programs using a model that is largely consistent with the guidance in the proposed standard. However, under U.S. GAAP, there is divergent practice in the accounting for loyalty

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programs with many entities following the incremental cost accrual model under which revenue is not allocated to the loyalty awards and the cost of fulfilling the awards is accrued. The proposed standard will therefore result in later revenue recognition for these companies. Example 9.1 Loyalty points: An entity grants its customers one point per $10 spent on purchases. Each point earned has a value of $1, which customers may redeem against future purchases. A customer purchases goods for $1,000 and earns 100 points redeemable against future purchases. The entity estimates that the stand-alone selling price of one point is $0.95 based on the redemption value of the points adjusted for the history of redemptions (that is, 5% breakage). The stand-alone selling price of the goods is $1,000. The option (loyalty points) provides a material right to the customer and is a separate performance obligation. The entity will allocate the total transaction price between goods and loyalty points based on their relative stand-alone selling prices. The transaction price allocated to the points will be recognized as revenue when the points are redeemed (and the related goods or services are transferred to the customer), or when they expire unused.
Product Points $913 $87 (1,000 x 1,000/1,095) (95 x 1,000/1,095)

The $913 of revenue allocated to the goods is recognized upon transfer of control of the goods and the $87 allocated to the points is recognized upon the earlier of the redemption or expiration of the points.

Licenses .51 A license is the right to use an entity's intellectual property. Intellectual property includes amongst others: software and technology; media and entertainment rights (for example, motion pictures and music); franchises; patents; trademarks; and copyrights. .52 An entity should recognize revenue from granting the right to use intellectual property when the customer obtains control of the rights. This occurs when control of the right to use the intellectual property transfers, but is no earlier than the beginning of the license period. .53 If there is more than one performance obligation in the arrangement, management will have to first assess whether the promised right to use intellectual property is a separate performance obligation, or if it should be combined with other performance obligations. PwC observation: The guidance in the proposed standard for licenses to use intellectual property could result in earlier revenue recognition than current practice under U.S. GAAP and IFRS. However, revenue might not be recognized immediately upon transfer of the right if the license is not distinct from other performance obligations in the contract. Additionally, there is often variable consideration in a license arrangement, in which case revenue recognition is constrained until the entity is reasonably assured to be entitled to the consideration. Revenue recognition is constrained until the customers future sales occur for sales-based royalty payments.

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Example 10.1 License to use intellectual property: A technology entity enters into a contract with Customer A to license its intellectual property for one year. The technology entity also enters into a contract with Customer B to provide a perpetual license to its intellectual property. Management will need to assess when the customer obtains control of the promised rights, which will determine when revenue should be recognized. Control of the rights to use intellectual property cannot be transferred before the beginning of the period during which the customer can use and benefit from those rights. In this example, the right to use the intellectual property for both Customer A and Customer B would transfer at the same point in time. The customer obtains control of the promised rights when the software license is transferred. If the contract includes other performance obligations in addition to the license, management will need to evaluate whether the right to use the intellectual property is distinct from those other performance obligations. If it is, revenue is recognized when control of the license is transferred (assuming the entity is reasonably assured to be entitled to the consideration). If it is not distinct, the right to use the intellectual property should be combined with other performance obligations until management identifies a bundle of goods or services that is distinct. Revenue is recognized when (or as) the combined performance obligation is satisfied.

Rights of return .54 An entity accounts for the sale of goods with a right of return as follows: Revenue is recognized for the consideration to which the entity is reasonably assured to be entitled (considering the products expected to be returned) and a liability is recognized for the refund expected to be paid to customers. The refund liability is updated for changes in expected refunds at each reporting period. An asset and corresponding adjustment to cost of sales is recognized for the right to recover goods from customers. The asset is initially measured at the original cost of the goods less any expected costs to recover those goods. Impairment is assessed at each reporting date. .55 A contract that provides the customer with the right to exchange one product for another product of the same type, quality, condition, and price (for example, a red shirt for a blue shirt) does not provide a return right accounted for under the proposed standard. PwC observation: Entities will be precluded from recognizing revenue prior to the lapse of the return right when management is unable to estimate returns, similar to current guidance. However, the proposed standard requires an entity to recognize an asset for the right to recover a product and an offsetting liability for the refund, which may be different from current practice. The asset recognized for the right to recover a product is assessed for impairment in accordance with existing standards.

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Warranties .56 An entity accounts for a warranty as a separate performance obligation if the customer has the option to the purchase the warranty separately. An entity accounts for a warranty as a cost accrual if it is not sold separately. However, if a warranty provides a customer with a service in addition to the assurance that the product complies with agreed specifications, that service is a separate performance obligation. .57 An entity that promises both a quality assurance and service-based warranty, but cannot reasonably separate the obligations and account for them separately, accounts for both warranties together as a separate performance obligation. PwC observation: The exposure draft provides a practical expedient to accounting for warranties and is generally consistent with current guidance under U.S. GAAP and IFRS. However, it might sometimes be difficult to separate a single warranty that provides both a standard warranty and a service. Determining the estimated stand-alone selling price for warranty-related services when such services are not sold separately could also be challenging.

Nonrefundable upfront fees .58 Some entities charge a customer a nonrefundable fee at the beginning of an arrangement. Examples may include setup fees, activation fees, or membership fees. Management needs to determine whether a nonrefundable upfront fee relates to the transfer of a promised good or service to a customer. .59 A nonrefundable upfront fee may relate to an activity undertaken at or near contract inception (for example, customer setup activities), but it does not indicate satisfaction of a separate performance obligation if the activity does not result in the transfer of a promised good or service to the customer. The upfront fee is recognized as revenue when goods or services are provided to the customer in the future. .60 If the nonrefundable upfront fee relates to a performance obligation, management needs to assess whether that performance obligation is distinct from the other performance obligations in the contract. Recognize revenue when each performance obligation is satisfied .61 The proposed standard includes guidance on the following areas when considering when each performance obligation is satisfied: Bill-and-hold arrangements Consignment arrangements Sale and repurchase of a product Bill-and-hold arrangements .62 Under a bill-and-hold arrangement, an entity bills a customer for a product but does not ship the product until a later date. Revenue is recognized on transfer of control of the goods to the customer. All of the following requirements must be met to conclude that the customer has obtained control in a bill-and-hold arrangement:

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The reason for the bill-and-hold arrangement must be substantive The product must be identified separately as the customer's The product must be ready for delivery at the time and location specified by the customer The entity cannot have the ability to sell the product to another customer .63 Management also needs to consider whether the custodial services of storing the goods are a material separate performance obligation to which some of the transaction price should be allocated. PwC observation: The proposed guidance and list of indicators for bill-and-hold transactions are generally consistent with the current guidance under IFRS. There may be situations where revenue is recognized earlier compared to current U.S. GAAP for bill-and-hold arrangements because there is no longer a requirement for the vendor to have a fixed delivery schedule from the customer in order to recognize revenue.

Consignment arrangements .64 Certain industries transfer goods to dealers or distributors on a consignment basis. The transferor typically owns the inventory on consignment until a specified event occurs, such as the sale of the product to a customer of the distributor, or until a specified period expires. .65 Management needs to consider the following factors to determine whether revenue should be recognized on transfer to the distributor or on ultimate sale to the customer: Whether the distributor has an unconditional obligation to pay for the goods Whether the entity can require return of the product or transfer to another distributor (which indicates that control has not transferred to the distributor) PwC observation: The proposed standard requires management to determine when control of the product has transferred to the customer. If the customer (including a distributor) has control of the product, including a right of return at its discretion, revenue is recognized when the product is delivered to the customer/distributor. Any amounts related to expected sales returns or price concessions affect the amount of revenue (that is, the estimate of the transaction price), but not when revenue is recognized. An entity that is unable to estimate returns, however, would not recognize revenue until the return right lapses, similar to todays model. The timing of revenue recognition could change for some entities compared to current guidance, which is more focused on the transfer of risks and rewards than the transfer of control. The transfer of risks and rewards is an indicator to assess in determining whether control has transferred under the proposed standard, but additional indicators will also need to be considered to determine whether control has transferred. If the entity is able to require the customer/distributor to return the product (that is, it has a call right), control has not transferred to the customer/distributor; therefore, revenue is only recognized when the products are sold to a third party.

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Example 11.1 Sale of products on consignment: A consumer products entity provides household goods to a retailer on a consignment basis. The retailer does not take title to the products until they are scanned at the register. Any unsold products are returned to the consumer products entity. Once the retailer sells the products to the consumer, the consumer products entity has no further obligations with respect to the products, and the retailer has no further return rights. The consumer products entity will need to assess whether the retailer has obtained control of the products, including whether the retailer has an unconditional obligation to pay the entity, absent a sale to the consumer. Revenue recognition prior to the sale to the consumer might not be appropriate. Additionally, if the consumer products entity retains the right to call back unsold product, control has not transferred and revenue is recognized only when the product is sold to the consumer.

Sale and repurchase of a product .66 When an entity has an unconditional obligation or unconditional right to repurchase an asset (a forward or a call option), the buyer does not obtain control of the asset because the buyer does not have the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. In this situation, an entity accounts for the transaction as follows: A lease, if the entity has the right or obligation to repurchase the asset for less than the original sales price of the asset A financing arrangement, if the entity has the right or obligation to repurchase the asset for an amount that is equal to or more than the original sales price of the asset .67 The entity continues to recognize the asset in a financing arrangement and recognizes a financial liability for any consideration received from the buyer. The difference between the amount of consideration received from the customer and the amount of consideration paid is interest expense. .68 When a customer has the right to require the entity to repurchase an asset (a put option), the arrangement should be accounted for as an operating lease (that is, the income is recorded over time) if the arrangement provides the customer a significant economic incentive to exercise that right, as the customer effectively pays for the right to use the asset over time. An arrangement is a financing if the repurchase price of the asset exceeds the original selling price and is more than the expected market value of the asset. PwC observation: Management needs to assess the nature of a sale and repurchase arrangement to determine whether the arrangement should be accounted for as a lease, as this determination is critical to applying the appropriate accounting model. The boards decided that if an entity enters into a contract with a repurchase agreement at a price less than the original sales price and the customer does not obtain control of the asset, the contract should be accounted for as a lease in accordance with Topic 840 or IAS 17, Leases.

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Contract costs .69 An entity recognizes an asset for the incremental costs to obtain a contract that management expects to recover. Incremental costs of obtaining a contract are costs the entity would not have incurred if the contract had not been obtained (for example, sales commission). An entity is permitted to recognize the incremental cost of obtaining a contract as an expense when incurred if the amortization period would be less than one year, as a practical expedient. .70 An entity recognizes an asset for costs to fulfill a contract when specific criteria are met. Management will first need to evaluate whether the costs incurred to fulfill a contract are in the scope of other standards (for example, inventory, fixed assets, intangibles). Costs that are in the scope of other standards should be either expensed or capitalized as required by the relevant guidance. .71 If fulfillment costs are not in the scope of another standard, an entity recognizes an asset only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations, and are expected to be recovered. .72 An asset recognized for the costs to obtain or costs to fulfill a contract should be amortized on a systematic basis as the goods or services to which the assets relate are transferred to the customer. An entity recognizes an impairment loss to the extent that the carrying amounts of an asset recognized exceeds (a) the amount of consideration the entity expects to receive for the goods or services less (b) the remaining costs that relate directly to providing those goods or services. PwC observation: Entities that currently expense all contract fulfillment costs as incurred might be affected by the proposed guidance since costs are required to be capitalized when the criteria are met. Fulfillment costs that are likely to be in the scope of this guidance include, among others, set-up costs for service providers and costs incurred in the design phase of construction projects. The proposed standard requires entities to capitalize incremental costs to obtain a contract that management expects to recover. This may be different from current practice where entities have the option to expense contract acquisition costs as incurred, allowing for diversity in practice.

Onerous performance obligations .73 An entity recognizes a liability and a corresponding expense if a performance obligation that is satisfied over a period of time greater than one year is onerous. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. The lowest cost of settling a performance obligation is the lower of (a) the amount the entity would pay to exit the performance obligation and (b) the costs that relate directly to satisfying the performance obligation by transferring the goods or services. .74 Performance obligations that are satisfied over a period of time less than a year are excluded from the onerous performance obligation assessment.

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PwC observation: Limiting the need to assess onerous performance obligations to only those obligations satisfied over a period of time greater than one year is narrower in scope than what had been proposed in the 2010 Exposure Draft. However, some additional complexity may have been introduced, for example, in determining whether (a) a contract requires satisfaction of a series of distinct performance obligations or a single performance obligation over time and (b) management expects the contract to exceed one year. There may also be a number of challenges in determining the appropriate costs to consider in the assessment. Processes and controls will need to be updated to closely monitor performance obligations satisfied over time and associated costs remaining to satisfy those obligations. Management will need to pay particular attention to contracts with decreasing revenue streams and flat or increasing costs as performance obligations are satisfied over time. These performance obligations could become onerous even if the contract is profitable overall. The proposed guidance will also accelerate the recognition of losses for "loss leader" contracts if such contracts include performance obligations satisfied over time. Example 12.1 Onerous performance obligations: A transportation entity signs a contract to provide ferry service for a local government. The contract requires the transportation entity to provide daily service for a three-year period at a fixed price per trip. Assume that there has been an unforeseen spike in fuel costs midway through the first year of the contract. Based on the current fuel costs, the contract is no longer profitable and the entity would have to pay a substantial penalty to terminate the contract early. The transportation entity will need to first assess whether the ferry service represents a series of individual distinct performance obligations per trip which are satisfied at a point in time, or whether the contract is one performance obligation that is satisfied over the three-year contract term. If management concludes that the ferry service is one performance obligation satisfied over a period of time beyond a year, it will be required to assess whether the performance obligation is onerous.

Disclosures
.75 The exposure draft includes a number of proposed disclosure requirements intended to enable users of financial statements to understand the amount, timing and judgment around revenue recognition and corresponding cash flows arising from contracts with customers. .76 The required disclosures include qualitative and quantitative information about contracts with customers, such as significant judgments and changes in judgments made in accounting for those contracts, and assets recognized from the costs to obtain or fulfill those contracts. The following are some of the key disclosures from the proposed standard:

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The disaggregation of revenue into primary categories that depict the nature, amount, timing and uncertainty of revenue and cash flows A tabular reconciliation of the movements of the assets recognized from the costs to obtain or fulfill a contract with a customer An analysis of the entity's remaining performance obligations including the nature of the goods and services to be provided, timing of satisfaction, and significant payment terms Information on onerous performance obligations and a tabular reconciliation of the movements in the corresponding liability for the current reporting period Significant judgments and changes in judgments that affect the determination of the amount and timing of revenue from contracts with customers Interim disclosures .77 The boards propose to amend existing interim disclosure guidance to specify the disclosures about revenue from contracts with customers that an entity should provide in interim financial statements. If material, the disclosures that would be required include most of the disclosures required in the annual financial statements. Nonpublic entity disclosures (U.S. GAAP only) .78 A nonpublic entity may elect not to provide any of the following disclosures: A reconciliation of contract balances The amount of the transaction price allocated to remaining performance obligations and when the entity expects to recognize revenue on that amount A reconciliation of liability balances recognized from onerous performance obligations A reconciliation of asset balances recognized from the costs to obtain or fulfill a contract with a customer An explanation of the judgments, and changes in judgments, used in determining the timing of satisfaction of performance obligations, determining the transaction price and allocating it to separate performance obligations

Transition
.79 The boards have not yet decided on the effective date of the proposed standard, except that it will be no sooner than annual periods beginning on or after January 1, 2015. Earlier adoption is not permitted under U.S. GAAP, although it will be permitted under IFRS. .80 The proposed guidance will be applied retrospectively. However, an entity may use one or more of the following practical expedients: An entity can elect not to restate contracts that begin and end within the same annual reporting period An entity may use the transaction price at the date the contract was completed rather than estimating variable consideration for contracts completed on or before the effective date
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An entity does not have to apply the onerous performance obligation test to performance obligations in comparative periods unless an onerous contract liability was recognized previously An entity is not required to disclose the amount of the transaction price allocated to remaining performance obligations with an explanation on the timing of revenue recognition (the so-called maturity analysis)

Next steps
.81 The comment period for the exposure draft ends on March 13, 2012. The boards continue to perform targeted consultation with key industries and other interested parties regarding some of the more significant changes. It is unclear when a final standard will be issued; however, the boards have indicated that the final standard will have an effective date no earlier than 2015.

Questions
.82 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact members of the Revenue team in the National Professional Services Group.

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Appendix Key differences between the 2010 and 2011 exposure drafts
(1) Identify the contract(s) with the customer (2) Identify and separate performance obligations (3) Determine the transaction price (4) Allocate the transaction price (5) Recognize revenue when a performance obligation is satisfied

Topic Combining contracts

2010 Exposure Draft

2011 Exposure Draft

An entity should combine two or more contracts if the prices of those contracts are interdependent.

An entity may need to combine two or more contracts entered into at or near the same time with the same customer if one or more of the following criteria are met: The contract is negotiated with a single commercial objective The amount of consideration paid in one contract depends on the other contract The goods or services promised between the contracts are a single performance obligation

Segmenting contracts

A single contract should be segmented into two or more contracts if some goods or services within the contract are independently priced from other goods or services in that contract. A contract modification is combined with the original contract if the prices of the original contract and the modification are interdependent (that is, treat the modification and original contract as one contract).

The contract segmentation guidance has been removed from the proposed standard. An entity should identify separate performance obligations in a contract. A contract modification is treated as a separate contract only if it results in the addition of a separate performance obligation and the price is reflective of the stand-alone selling price of that additional performance obligation.

Contract modifications

1 2

Refers to the exposure draft issued on June 24, 2010 Refers to the exposure draft issued on November 14, 2011
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(1) Identify the contract(s) with the customer

(2) Identify and separate performance obligations

(3) Determine the transaction price

(4) Allocate the transaction price

(5) Recognize revenue when a performance obligation is satisfied

Topic Performance obligations

2010 Exposure Draft Performance obligations are enforceable promises (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer. An entity recognizes revenue from performance obligations separately if the goods or services are distinct. A good or service is distinct if an entity sells an identical or similar good or service separately. A good or service that has a distinct function and a distinct profit margin from the other goods or services in the contract is also distinct, even if not sold separately.

2011 Exposure Draft Performance obligations are promises in a contract to transfer goods or services to a customer. The term enforceable was removed from the definition in the proposed standard. A separate performance obligation exists if the goods or services are distinct. Goods or services are distinct if: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with resources readily available to the customer. A bundle of goods or services is accounted for together as one performance obligation if both of the following criteria are met: The goods and services are highly interrelated and the entity provides a significant service of integrating goods and services into the combined item that the customer has contracted for The entity is contracted by the customer to significantly modify or customize the goods or services

Identification of separate performance obligations

Warranties

Revenue is deferred for warranties that require replacement or repair of components of an item, but only for the portion of revenue attributable to the components that must be repaired or replaced. Warranties that provide the customer with coverage for faults that arise after the entity transfers control to the customer give rise to a separate performance obligation.

Warranties that the customer has the option to purchase separately are accounted for as a separate performance obligation. An entity should account for a warranty as a cost accrual if it is not sold separately and the warranty does not provide a service in addition to a standard warranty. An entity that promises both a quality assurance and service-based warranty but cannot reasonably separate them, should account for both as separate performance obligations.

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(1) Identify the contract(s) with the customer

(2) Identify and separate performance obligations

(3) Determine the transaction price

(4) Allocate the transaction price

(5) Recognize revenue when a performance obligation is satisfied

Topic Variable consideration

2010 Exposure Draft The transaction price is the consideration that the entity expects to receive from the customer. The transaction price includes the probability-weighted estimate of variable consideration when management can make a reasonable estimate of the amount to be received. An estimate is reasonable only if an entity: has experience with similar types of contracts, and does not expect circumstances surrounding those types of contracts to change significantly.

2011 Exposure Draft The transaction price is the consideration that the entity is entitled to under the contract, including variable or uncertain consideration. It is based on the probabilityweighted estimate or most likely amount of cash flows entitled from the transaction, depending on which is most predictive of the amount to which the entity is entitled. Revenue on variable consideration is only recognized when the entity is reasonably assured to be entitled to it.

Collectibility

Collectibility is not a hurdle to recognition of revenue. The transaction price is adjusted to reflect the customer's credit risk by recognizing the consideration expected to be received using a probability-weighted approach. Changes in the assessment of consideration to be received due to changes in credit risk are recognized as income or expense, separately from revenue.

Collectibility of the transaction price is not a hurdle to revenue recognition. The transaction price is presented without adjustment for credit risk. An allowance for the expected impairment loss on receivables is presented in a separate line item adjacent to revenue. Both the initial impairment assessment and any subsequent changes in the estimate of collectibility are recorded in this line (if the contract does not have a significant financing component). The transaction price should reflect the time value of money when the contract includes a significant financing component. As a practical expedient, an entity is not required to reflect the effects of the time value of money in the measurement of the transaction price when the period between payment by the customer and the transfer of the goods or services is less than one year.

Time value of money

The transaction price reflects the time value of money whenever the contract includes a material financing component.

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(1) Identify the contract(s) with the customer

(2) Identify and separate performance obligations

(3) Determine the transaction price

(4) Allocate the transaction price

(5) Recognize revenue when a performance obligation is satisfied

Topic Allocation method

2010 Exposure Draft The transaction price is allocated to separate performance obligations based on the relative stand-alone selling price of the performance obligations in the contract. An entity may not use the residual method to allocate the transaction price.

2011 Exposure Draft The transaction price is allocated to separate performance obligations based on the relative stand-alone selling price of the performance obligations in the contract. A residual value approach may be used as a method to estimate the stand-alone selling price when there is significant variability or uncertainty in the selling price of a good or service, regardless of whether that good or service is delivered at the beginning or end of the contract. Some elements of the transaction price, such as uncertain consideration, discounts or change orders, may be allocated to only one performance obligation rather than all performance obligations in the contract under certain circumstances.

Breakage

An entity should consider the impact of breakage (forfeitures) in determining the transaction price allocated to the performance obligations in the contract.

The entity should recognize the effects of the expected breakage as revenue in proportion to the pattern of rights exercised by the customer if the amount of expected breakage is reasonably assured. The entity should recognize the effects of the expected breakage when the likelihood of the customer exercising its remaining rights becomes remote, if the amount of breakage is not reasonably assured.

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(1) Identify the contract(s) with the customer

(2) Identify and separate performance obligations

(3) Determine the transaction price

(4) Allocate the transaction price

(5) Recognize revenue when a performance obligation is satisfied

Topic Transfer of goods

2010 Exposure Draft Revenue is recognized when a promised good or service is transferred to the customer. An entity transfers a promised good or service and satisfies a performance obligation when the customer obtains control of that good or service. A customer obtains control of a good or service if it has the ability to direct the use of and receive the benefit from the good or service. Performance obligations can be satisfied at a point in time or continuously over time. Indicators that the customer has obtained control of the good or service may include: The customer has an unconditional obligation to pay The customer has legal title The customer has physical possession The customer specifies the design or function of the good or service

2011 Exposure Draft An entity recognizes revenue for the sale of a good when the customer obtains control of the good. Indicators that the customer has obtained control of the good include: The customer has an unconditional obligation to pay The customer has legal title The customer has physical possession The customer has risks and rewards of ownership The customer provided evidence of acceptance

Continuous transfer of goods and services

The exposure draft had no specific guidance for services. The guidance was the same as the guidance for goods above.

An entity must determine if a performance obligation is satisfied continuously to determine when to recognize revenue for certain performance obligations. The entity should then select a method for measuring progress in satisfying that performance obligation. An entity should recognize revenue for performance obligations satisfied continuously only if the entity can reasonably measure its progress toward completion. A performance obligation is satisfied continuously if (a) the entity's performance creates or enhances an asset that the customer controls, or (b) the entity's performance does not create an asset with alternative use to the entity but one of the following criteria is met:

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Dataline 32

Topic

2010 Exposure Draft

2011 Exposure Draft The customer simultaneously receives and consumes the benefits of the entitys performance as it performs Another entity would not need to substantially re-perform the task(s) if that other entity were required to fulfill the remaining obligation to the customer The entity has a right to payment for performance completed to date and it expects to fulfill the contract

Measuring progress of satisfying a performance obligation

Methods for recognizing revenue when control transfers continuously include: Output methods that recognize revenue on the basis of units produced, units delivered, contract milestones, or surveys of work performed Input methods that recognize revenue on the basis of costs incurred, labor hours expended, or machine hours used Methods based on the passage of time

The objective is to faithfully depict the pattern of transfer of the goods or services to the customer. Methods for recognizing revenue when control transfers continuously include: Output methods that recognize revenue on the basis of the value of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved) Input methods that recognize revenue on the basis of inputs to the satisfaction of a performance obligation (for example, time, units delivered, resources consumed, labor hours expended, costs incurred, and machine hours used) An entity may select an appropriate input method if an output method is not directly observable or available to an entity without undue cost. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if the costs of goods are significant and transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials).

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Dataline 33

Topic Constraint on recognizing revenue

2010 Exposure Draft Amounts are only included in the transaction price allocated to performance obligations if they can be reasonably estimated.

2011 Exposure Draft Revenue is recognized when the performance obligation is satisfied and the entity is reasonably assured to be entitled to the transaction price allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration if both of the following criteria are met: The entity has experience with similar types of performance obligations The entity's experience is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations There is an exception regarding licenses to use intellectual property in exchange for royalties based on the customer's subsequent sales of a good or service. The related variable consideration only becomes reasonably assured once those future sales occur.

Licenses and rights to use

The contract is a sale of intellectual property if the customer obtains control of the entire licensed intellectual property (for example, the exclusive right to use the license for its economic life). The performance obligation is satisfied over the term of the license if the customer licenses intellectual property on an exclusive basis but does not obtain control for the entire economic life of the property. A contract that provides a nonexclusive license to use intellectual property (for example, off-the-shelf software) is a single performance obligation. An entity recognizes revenue when the customer is able to use the license and benefit from it.

The promised rights are a performance obligation that the entity satisfies when the customer obtains control (that is, the use and benefit) of those rights. An entity should consider whether the rights give rise to a separate performance obligation or whether the rights should be combined with other performance obligations in the contract.

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Dataline 34

Other considerations

Topic Costs of obtaining a contract

2010 Exposure Draft An entity recognizes costs to obtain a contract (for example, costs of selling, marketing, or advertising) as incurred.

2011 Exposure Draft Costs to obtain a contract should be recognized as an asset if they are incremental and expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained. Costs to fulfill a contract are in the scope of the proposed guidance only if those costs are not addressed by other standards. Costs required to be expensed by other standards cannot be capitalized under the proposed guidance. An entity should recognize an asset for costs that are not within the scope of another standard only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations in a contract, and are expected to be recovered under a contract. An entity amortizes an asset recognized for fulfillment costs in accordance with the transfer of goods or services to which the asset relates, which might include goods or services to be provided in future anticipated contracts. An entity should recognize a liability and corresponding expense if a performance obligation that is satisfied over a period of time is onerous. The performance obligation will not need to be assessed if it is satisfied over a period less than one year. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of transaction price allocated. The lowest cost of settling a performance obligation is the lower of the following:

Costs of fulfilling a contract

An entity may capitalize the costs to fulfill a contract in certain circumstances. Management will need to evaluate whether the costs incurred in fulfilling a contract are in the scope of other standards (for example, inventory, fixed assets, intangibles) to determine which costs may be recognized as an asset. An entity should recognize an asset for costs that are not within the scope of another standard only if the costs relate directly to a contract, will generate or enhance a resource that the entity will use to satisfy future performance obligations in a contract, and are expected to be recovered under a contract.

Onerous performance obligations

A performance obligation is onerous when the present value of the probabilityweighted direct costs to satisfy the obligation exceed the consideration (that is, the amount of transaction price) allocated to it.

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Dataline 35

Topic

2010 Exposure Draft

2011 Exposure Draft The costs directly related to satisfying the performance obligation The amount the entity would have to pay to exit the performance obligation

Sale and repurchase agreements (put options)

An entity should account for the transaction as a sale of a product with a right of return when it sells a product to a customer that includes an unconditional right to require the entity to repurchase that product in the future.

Arrangements where a customer has the right to require the entity to repurchase an asset (a put option) should be accounted for as a lease under the leasing standard if the arrangement represents a right to use the asset over time rather than a sale.

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Dataline 36

Authored by:
Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Dusty Stallings Partner Phone: 1-973-236-4062 Email: dusty.stallings@us.pwc.com Guilaine Saroul Director Phone: 1-973-236-7138 Email: guilaine.saroul@us.pwc.com Steve Mack Senior Manager Phone: 1-973-236-4378 Email: steve.mack@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com Andrea Allocco Senior Manager Phone: 01144-207-212-3722 Email: a.allocco@uk.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

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10 Minutes
The far-reaching implications of a new revenue model
Highlights Management should evaluate existing business practices under the new model, including how product or service offerings are bundled and priced, and begin assessing the need to negotiate revised contract terms. Industry-specic accounting guidance will be eliminated under the new model and industry practice will need to be re-evaluated. Estimates that are required to apply the new model will often require the use of greater judgment and may necessitate process or system changes. Companies should begin assessing the impact of the changes and the adequacy of their resources, systems, and processes to address the newrequirements.

on the future of revenue recognition

July 2011

Revenue, or the top line, is one of the most closely-monitored measures in financial statements. However, the accounting rules for revenue can be difficult to decipher. US revenue guidance today is a tangled web of special rules and exceptions created to address unique transactions, industries, and business models. The FASB and IASB are in the process of replacing this labyrinth of revenue guidance with a new global accounting standard that will apply a single set of principles to all revenue transactions, regardless of industry. Their proposed standard, issued in June 2010, received extensive feedback, which the boards have discussed at length during the first half of 2011. Now that theyve completed their initial redeliberations and decided to re-expose their revenue proposal, its time to take stock of the effects. Understanding the impact now will inform your response to the revised proposal and limit surprises down the road. This 10Minutes provides a preview of the proposed changes and their implications. We expect the FASB and IASB to issue a revised exposure draft in August or September 2011 and a final standard in the September 2012 timeframe. Keep in mind that some aspects of the guidance could change before a final standard is issued.

What it means for your company: 1. Revenue is a key metric subject to considerable focus by investors and other stakeholders. The impact of changes to the revenue model will affect key financial measures and ratios. Early communication to stakeholders will becritical. 2. Companies may need to change information technology systems to capture different information and develop new processes for estimates that arent requiredtoday. 3. The resulting need for increased judgment will require thoughtful documentation and dialogue with those charged withgovernance. 4. It may be necessary to modify contract terms to maintain the original intent of arrangements or better align reported revenue with business objectives. 5. Adopting the new guidance will entail adjusting prior period financial statements. Successful implementation of the standard will require upfront planning. 6. The FASB and IASB have decided to reexpose their proposed revenue standard. Companies should take advantage of this opportunity to participate in the standardsetting process and provide input to theboards.

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At a glance

A principles-based approach The proposed model is easy to understand on its surface, but its application could result in significant changes from existing practice. A few highlights of the revenue proposal1 include: Revenue is recognized when control is transferred to the customer, a new model that requires judgment for many transactions.

with potential for big implications The implications will vary by company and by industry. But at a minimum, companies will need to consider the following: Industry practices that have developed over time are now off the table. It may take time for interpretations to develop and practices to evolve for some aspects of the new model.

Revenue reflects a more extensive use of estimates Most companies will see some impact on margins (for example, contingent fees), and bad debt and other key financial measures. Changes estimates offset gross revenue. that affect a broad base of companies include offsetting bad debt expense against revenue and Revenue from licenses of intellectual property is changes in the timing of recognizing certain costs. recognized when the customer obtains control of the rights, which could result in fewer license fees recognized ratably over the license period.

Direct costs of obtaining and fulfilling contracts are capitalized as assets if they meet certain criteria, bringing consistency to an area of mixed practicetoday.

Changes in how contract terms affect reported revenue, such as contingent fees and prepayments or extended payment terms, could influence how companies and their customers negotiate theseterms. Any change to revenue is likely to affect a wide range of arrangements that are linked to financial measures, including compensation and bonus plans, earnout arrangements, and covenants in financial agreements. Changes to revenue might also have tax implications and could affect the timing of cash tax payments if, for example, revenue recognition is accelerated.

1 The discussion of the proposed guidance throughout this document is based on the proposals in the June 2010 exposure draft and tentative decisions reached during redeliberations as of June 30, 2011. Certain provisions may change before the nal standard isissued.

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01
No more special treatment
Industry-specic US revenue guidance will be largely eliminated including:

Financial services Brokers and dealers Depository and lending Investment companies Mortgage banking

A primary goal of the standard setters is to create a single, principles-based approach thats applied across all industries. So, companies that previously followed industry-specific guidance or established industry practices will likely feel the greatest impact. Assessing this impact now may reveal potential longer-term strategic matters to consider even before the standard is finalized. The examples below represent only a small sample of affectedindustries. Software The detailed rules in todays software guidance were designed with an anti-abuse bias and often delay revenue recognition. Software companies have shaped their business models to address the strict requirements; for example, by including renewal rates in contracts, putting limits on discounts offered to customers, and avoiding promises for future technology. The less rigid approach in the new model may eliminate the need for these restrictions and may cause software companies to rethink their current practices. As a result, some may change how they sell their products and services, and how they negotiate with customers. Real estate Industry-specific guidance for real estate includes prescriptive requirements in areas such as the continuing involvement of the seller and evidence of the buyers commitment to pay for a property. The new model takes more of a principles-based approach that eliminates these bright lines. Thus, companies may decide to modify arrangements

that were previously structured to meet brightline requirements to better align with their businessobjectives. Contractors Those in the engineering and construction, and aerospace and defense industries, among others, currently apply specific guidance on longterm contracts. This guidance includes rules for recognizing revenue (usually on a percent-complete basis), recording contract costs, and accounting for change orders. The new model has similar concepts but there are nuances that could catch some by surprise. For example, there could be differences in the costs that are capitalized or how progress to completion is measured. At the extreme, some arrangements might not result in revenue until the project is complete. Each company will have to assess its own specific facts under the new model. Can one size fit all? The standard setters have encountered some bumps in the road over the course of the revenue project. It hasnt been easy to craft a principles-based approach that functions as intended for all industries. The FASB and IASB plan to issue a revised exposure draft in August or September 2011, with a 120-day comment period. Companies with concerns about unintended consequences of the model should take advantage of this opportunity to influence the standard-setting process.

Entertainment Broadcasters Cable television Casinos Films Music

Other industries Airlines Contractors Extractive activities-oil and gas Franchisors Health care entities Real estate Software

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02
Navigating areas ofjudgment
A principles-based approach, by design, requires more judgment than applying a set of rules. While the standard setters have agreed to add more guidelines and indicators in some areas, accounting for revenue will likely require a greater use of estimates and judgment than it does today. We highlight just a few areas requiring estimates or judgments and the related process implicationsbelow. New estimates of variable fees Revenue under the new model is based on the total fees a company expects to receive. This includes estimates of variable fees, such as performance bonuses, royalties, and other contingent fees. Recognition of revenue for fees with these types of uncertainties is often deferred today. Under the new model, there are still some constraints on recording revenue, particularly for contingencies outside the companys control. But some fees might be recognized earlier than today, and potentially adjusted along the way, requiring new processes to estimate these amounts. A new model for credit risk A change affecting almost all companies is the treatment of bad debts. Today, a company defers all of the revenue from a contract when it cant be assured of collecting from the customer at the onset of the arrangement. Under the new model, this hurdle has been removed. Also, estimates of uncollectible amounts will offset gross revenue, instead of being recorded as bad debt expense. In addition to affecting margins, these changes require recording a day one estimate of customer credit losses for all transactions. Loss leaders in service contracts Today, contract losses are generally not recorded until incurred, except when applying certain industry guidance. A loss could be recorded upfront under the new model, however, when estimated costs to fulfill a service obligation exceed remaining revenue. For example, a service provider might sign a one-year contract with a customer that is unprofitable, anticipating that the customer will renew for future years. A loss will likely be recorded at contract inception in this scenario. The new model will require forecasting costs and updating estimates on an ongoing basis to identify potential losses. Because its an ongoing assessment, a loss could be triggered part way through a contract if costs begin to climb. System and process implications Revenue estimates will be based on the probabilityweighted or most likely amount of cash flows. New systems and processes may be needed to collect and analyze data for developing and continuously reassessing these estimates. Companies will also likely need new processes for other areas of judgment, including allocating revenue to performance obligations, tracking customer credit risk, identifying loss contracts, and analyzing capitalized costs. The judgment required when applying a principles-based approach continues to raise concerns. A common concern is that judgments and estimates can be challenged by others in hindsight. Thats why its essential to establish good processes, thoughtfully document estimates on a contemporaneous basis, and ensure they are subject to the appropriate oversight.

Examples of estimates required by the revenue standard

Bad debts/ credit risk

Record estimated bad debts as an offset to gross revenue Updates to estimates also affect net revenue

Performance bonuses

Estimate the amount the company expects to receive Generally recognize if reasonably assured based on experience and other factors

Royalties and other variable fees

Estimate the amount the company expects to receive Generally do not recognize if sales-based royalties or no predictive experience

Time value of money

Only record impact if significant and greater than one year Could affect contracts with prepayments or extended payment terms

Loss contracts

Record upfront loss if remaining costs exceed revenue for service obligations Update assessment throughout the life of the contract

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03
Assessing the impact on the past, present, and future
A fresh look at contract terms Applying the new model is almost like starting with a clean sheet of paper. This fresh look could prompt changes to contract terms or other business strategies. Now that the standard setters are about to release a revised exposure draft, its time to start thinking ahead about potential strategic changes. An important first step is analyzing existing sales transactions and modeling the impact of the proposed guidance. This could reveal areas where changes are warranted. Management should also reassess business practices that have been influenced by the existing revenue rules. For example, some may bundle or price their offerings in a way to achieve, or avoid, deferral of revenue. Similarly, some may structure arrangements to comply with brightline requirements. These strategies might not be necessary under the new model, or consistent with broader business objectives. Because changes to business practices cant be implemented overnight, companies should think through these issues well in advance of adopting the new standard. Other affected arrangements Due to the pervasive impact of revenue on the financial statements, other arrangements linked to financial measures could be affected. These arrangements might include compensation and bonus plans, earnout arrangements, and covenants in financing agreements, among others. Companies should inventory affected arrangements and assess the impact of changes to the relevant financial measures. In some instances, it may be necessary to modify the terms of these arrangements to maintain their original intent. Adopting the new standard Companies will adopt the new standard by adjusting prior period financial statements as if the guidance had always been applied, with a few practical exceptions provided to reduce the burden. Most agree this approach is conceptually superior as it provides consistency across reporting periods. Gathering data on historical transactions, however, could be challenging, particularly for companies with multi-year contracts. Getting an early start will be key to overcoming these challenges. Managing the transition period For a period of time prior to the effective date, most companies will need to implement some form of parallel or dual tracking of transactions under both the current and new guidance. This analysis will be needed to adjust prior periods on the effective date, but it is also important information for communicating the impact of the new standard tostakeholders. Another challenge during the transition period is planning the timing of strategic changes, such as changes to contract terms. Prior to the effective date of the new standard, reported revenue will continue to reflect existing guidance. However, these same transactions will be reported under the new guidance when prior periods are adjusted upon adoption. The contracts terms in a given arrangement will dictate how it is accounted for under both sets of guidance. Some companies may decide to delay changes to contract terms until they have adopted the new guidance. Regardless of the approach taken, communicating these decisions and their implications to stakeholders will be critical to avoid surprises.

Illustrative timeline for implementing the new standard The boards have yet to decide on the effective date of the nal standard; however, the FASB recently announced that the effective date would be no earlier than annual periods beginning on or after January 1, 2015. The below timeline illustrates key timing considerations, including the transition period, if the effective date is January 1, 2015. January 2013: First September reported period 2012: adjusted Final upon standard expected adoption

January 2015: Illustrative effective date

Implement new processes and procedures

Assess transactions under both sets of guidance (dual recordkeeping)

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04
What should your company be doingnow?
While the standards effective date is still a few years away, its successful implementation will require planning ahead and keeping stakeholders well-informed of the changes to come. Key steps in the process include: Rally the people who need to act Assemble a steering committee. Include resources from legal, tax, operations, information technology, human resources, sales and marketing, and investor relations. Educate business leaders in the company about the changes and business implications. Inform the audit committee and others charged with governance and oversight responsibilities. Develop a point of view on the revised exposure draft (when issued) and provide input to the boards during the comment letter period. Assess the potential impact early
Identify gaps in systems and controls

Consider new systems and controls Assess whether current systems can capture and process the data needed to develop and monitor new required estimates, and track potential differences in revenue for book and tax purposes. Develop a plan to implement dual recordkeeping of transactions during the transition period. Consider the need for new systems and the time requirements to implement and test them. Identify processes and controls that need to be designed or modified, documented, and implemented. Conduct strategic reviews Utilize forecasting models to assess expected changes in reported revenue, gross margin, and other key financial measures. Evaluate potential changes to business practices, including whether to modify existing contract terms. Assess when strategic changes should be enacted (i.e., before or after the standards effective date). Educate the sales force about the changes and assess how the changes will affect negotiations with customers; consider whether any controls related to the sales process need to be modified or put in place. Communicate in advance with stakeholders Develop a plan to limit surprises by communicating the expected impact to investors and other stakeholders.

Preparing for the change

Form a cross-functional steering committee

Inventory affected contract provisions

Review existing revenue arrangements and contracts to identify provisions that will beaffected. Model the impact on significant sales transactions or a sample of transaction types. Assess the potential impact on other arrangements linked to key financial measures, such as compensation plans or debt covenants. Assess the potential tax implications, as the timing of cash tax payments could be affected, and consider the need to pursue approval for changes to existing methods of accounting used for tax purposes.

Evaluate potential changes to business practices

Develop a plan to communicate to stakeholders

At a glance

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Upcoming 10Minutes topics

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How PwC can help

To have a deeper discussion about the change in revenue accounting standards, please contact: Jim Kaiser Partner, US Convergence & IFRS Leader PwC 267-330-2045 james.kaiser@us.pwc.com Dave Kaplan Partner, Co-Leader National Accounting Services Group PwC 973-236-7219 dave.kaplan@us.pwc.com David Schmid Partner, US Assurance IFRS Leader PwC 312-298-2939 david.schmid@us.pwc.com Dusty Stallings Partner, National Accounting Services Group PwC 973-236-4062 dusty.stallings@us.pwc.com

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US GAAP Convergence & IFRS Revenue recognition: Aerospace and defense supplement

Dataline A look at current financial reporting issues


No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Determining the unit of account ............. 2 Determining transfer of control ...................... 5 Contract costs ............... 10 Onerous performance obligations ................... 13 Long-term maintenance contracts ...................... 14 Other considerations ..... 16

Revenue from contracts with customers The proposed revenue standard is re-exposed

Aerospace and defense industry supplement


Overview
The following items common in the Aerospace and Defense (A&D) industry are expected to be significantly impacted by the new revenue recognition standard. Currently, several accounting standards are commonly used to recognize revenue and related costs in the A&D industry. Defense programs and commercial aviation equipment are often complex, expensive programs, and performance under these contracts typically spans multiple years. Construction contract guidance is generally followed for these programs. Long-term maintenance contracts for commercial aviation equipment and performance-based logistics contracts for military equipment are also common. These contracts can extend up to 20 years and require significant estimates of costs to perform under these contracts over the performance period. This paper, the examples, and the related assessments contained herein, are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on November 14, 2011. These proposals are subject to change until a final standard is issued. The examples reflect the potential effect based on the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the 2010 Exposure Draft). References to the proposed model or proposed standard refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard refer to PwC's Dataline 2011-35 or visit www.fasb.org.

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

Dataline

Determining the unit of account


Current guidance requires that the contract is the unit of account, except in circumstances where the contract meets the criteria for combining contracts or segmenting a contract. The proposed standard requires consideration of the separate performance obligations in a contract. The complexity of A&D contracts might make it challenging to determine the unit of account for applying the new guidance. Contracts commonly contain integrated systems and combinations of products and services. The exposure draft further indicates that a promised bundle of goods or services shall be accounted for as a single performance obligation if the goods or services in the bundle are significantly customized, highly interrelated, and the entity provides a significant service of integrating the goods or services into the combined item(s). Proposed model Performance obligations A performance obligation is a promise to transfer a good or service to a customer. An entity should separately account for performance obligations if the pattern of transfer is different and they are distinct. A good or service is distinct if either of the following criteria are met: The unit of account for measuring contract performance and recognizing revenue is typically the contract. That presumption may be overcome only if a contract or a series of contracts meets the conditions for combining or segmenting contracts. The unit of account for measuring contract performance and recognizing revenue is typically the contract. That presumption is overcome when a contract or a series of contracts meets the conditions described for combining or segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract. Current U.S. GAAP Current IFRS

There is no further guidance for separately accounting for more than The entity regularly sells the good or one deliverable in a construction contract under the construction service separately contract guidance. The customer can use the good or service on its own or together with other readily available resources

An entity should account for two or more performance obligations as a single performance obligation when the following criteria are met: The goods or services are highly interrelated and transferring them to the customer requires the entity to provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted The bundle of goods or services is significantly modified or customized to fulfill the contract Goods and services that are not distinct and therefore, not separate performance obligations, should be combined with other performance obligations until the entity identifies a bundle of goods or services that is distinct.

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

Dataline

Proposed model Contract options An option in a contract to acquire additional goods or services is a separate performance obligation if it provides a material right to the customer that the customer would not have received without entering into the contract. An example of a material right is a significant discount on additional goods or services that is not available to similar customers. A portion of the transaction price is allocated to the option based on the estimated standalone selling price of the option. Contract modifications A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the promised goods or services underlying that performance obligation. A modification that is not a separate contract is evaluated and accounted for either as: A termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification A cumulative adjustment to contract revenue if the goods and services are not distinct and part of a single performance obligation that is partially satisfied A prospective adjustment to contract revenue when the goods or services are a combination of distinct and non-distinct

Current U.S. GAAP

Current IFRS

Contract options, which are generally an option to purchase additional units of a product at previously agreed upon pricing, might be included in the original contract or accounted for separately, depending on the circumstances.

Contract options, which are generally an option to purchase additional units of a product at previously agreed upon pricing, might be included in the original contract or accounted for separately, depending on the circumstances.

A change order is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. U.S. GAAP includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be performed is defined, but the price is not).

A change order (known as a variation) is included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders. A change order is generally included in contract revenue when it is probable that the customer will approve the change order and the amount of revenue can be reliably measured.

National Professional Services Group | CFOdirect Network www.cfodirect.pwc.com

Dataline

Proposed model Combining contracts Two or more contracts entered into at or near the same time and with the same customer are combined and accounted for as one contract if one of the following conditions is met: The contracts are negotiated as a single package The amount of consideration paid in one contract depends on the other contract The goods or services promised are a single performance obligation Impact:

Current U.S. GAAP

Current IFRS

Combining contracts is permitted provided certain criteria are met. Combining is not required as long as the underlying economics of the transaction are fairly reflected.

Combining contracts is required when certain criteria are met.

The unit of account for recognizing revenue will no longer default to the contract level. Preparers will need to apply and document their judgments regarding the identification of performance obligations within a contract and when performance obligations should be separately accounted for or combined. The proposed guidance introduces the concept of determining whether a good or service is distinct. A&D contracts often involve complex integrated systems, requiring judgment to determine whether aspects of these systems represent a distinct good or service. Another concept introduced in the proposed standard is the concept of accounting for a bundle of goods or services as a single performance obligation if the entity provides significant customization, the goods and/or services are highly interrelated and the entity provides a significant service of integrating goods and/or services into the combined item(s) for which the customer has contracted. Significant judgment may be required to determine if providing a bundle of goods and/or services meets these criteria. A contract option that provides the customer a material right the customer would not have otherwise received results in a separate performance obligation with a portion of the transaction price allocated to the right. An option that provides a right to additional goods or services at a price within the range of prices typically charged does not result in a material right and therefore, does not result in a separate performance obligation. Contract modifications currently require significant judgment to determine when they are combined with the original contract, and we expect that to continue. The criteria used to combine contracts have not changed significantly. Combining is no longer optional if the criteria are met, which is a change from existing U.S. GAAP.

Key changes from the June 2010 Exposure Draft: The basic principle of accounting for performance obligations separately has not changed from the June 2010 exposure draft. The boards have provided additional guidance on when a bundle of goods or services could result in a single performance obligation in an effort to better reflect the economics of certain long-term contracts. The boards also revised the guidance for determining whether a performance obligation is distinct. The concept of a distinct profit margin was removed. The focus is now on whether the good or service is sold separately by the entity or whether the good can be used with other resources readily available to the customer. The guidance on segmenting contracts was removed as it was deemed unnecessary given the requirement to separate contracts into distinct performance obligations.

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Example #1 Identification of performance obligations


Facts: A contractor enters into a contract to design and build a series of ten identical unmanned aircraft (a "low rate initial production" or "LRIP"). How many distinct performance obligations are there in the contract? Discussion: The identification of performance obligations in a contract might require considerable judgment. The design services and build of the complex systems for this LRIP might be distinct, but the specific facts and circumstances of the contract will need to be assessed. The contractor may be able to account for the bundle of goods and services (design and build) as a single performance obligation if the goods and services are significantly customized, highly interrelated, and the contractor provides a significant service of integrating goods or services into the combined item(s). Full rate production contracts that do not include design services will also require judgment to determine whether the goods and services are significantly customized and highly interrelated based on the contract terms. Each deliverable under the contract might be a separate performance obligation, particularly in the absence of a significant service to integrate the goods and/or services.

Example #2 Unpriced change orders


Facts: A contractor has a history of executing unpriced change orders; that is, those change orders where the price is not defined until after scope changes are in process or completed. When will these change orders be included in contract revenue? Discussion: The contractor might be able to determine that it expects the price of the scope change to be approved based on its historical experience. If so, the contractor would account for the unpriced change order and estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is most predictive). The contractor would need to then determine whether the unpriced change order should be accounted for as a separate contract. This will often not be the case based on the following: Change orders often wont result in a separate performance obligation because the underlying good or service is highly interrelated with the original good or service and part of the contractor's service of integrating goods into a combined item for the customer. Change orders are typically priced based on the contractor's single commercial objective for the overall contract. The pricing of a change order may, as a result, not represent the standalone selling price of the additional good or service. The contractor would update the transaction price and measure of progress towards completion of the contract accordingly when a change order is combined with the original contract and the remaining goods or services are part of a single performance obligation that is partially satisfied.

Determining transfer of control


Many entities in the A&D industry use percentage-of-completion accounting to recognize revenue as activities are performed. The percentage of completion is measured using either output methods, such as units-of-delivery, or input methods, such as cost incurred compared to total estimated cost at completion. The boards have proposed that revenue is recognized upon the satisfaction of a contractor's performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. The change to a control transfer model will require careful assessment of when a contractor can recognize revenue. We expect that many A&D contracts will transfer control of a good or service over time and, therefore, might result in revenue being recognized in a pattern similar to today. This should not be assumed, however. Contractors will not be able to default to the method used today and a careful assessment of when control transfers will need to be performed.

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Proposed model Transfer of control Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps most important for the A&D industry, over time.

Current U.S. GAAP

Current IFRS

Many entities in the A&D industry use percentage-of-completion accounting to recognize revenue when reliable estimates are available.

Many entities in the A&D industry use percentage-of-completion accounting to recognize revenue when reliable estimates are available. When reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall loss), the percentage-of-completion method based on a zero-profit margin is used until more precise estimates can be made. The completed-contract method is prohibited. Assessing whether a contract is within the scope of the construction contract standard or the broader revenue standard continues to be an area of focus. A buyers ability to specify the major structural elements of the design is a key indicator (although not determinative in and of itself) of construction contract accounting. Construction accounting guidance is generally not applied to the recurring production of goods.

When reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (for A performance obligation is satisfied example, when the scope of the over time when at least one of the contract is ill-defined, but the following criteria is met: contractor is protected from an overall loss), the percentage-of-completion The entity's performance creates or method based on a zero-profit margin is used until more precise estimates enhances an asset that the can be made. customer controls; or The entity's performance does not create an asset with alternative use to the entity; and at least one of the following: The customer simultaneously receives and consumes the benefits as the entity performs, Another entity would not need to substantially reperform the work performed to date if that other entity were required to fulfill the remaining obligation to the customer, or The entity has a right to payment for performance completed to date. The completed-contract method is required when reliable estimates cannot be made. Assessing whether a contract is within the scope of the construction contract guidance is a key determination. Many A&D contracts are specifically scoped into the U.S. GAAP contract accounting guidance today given the customer specifies the major elements of the design.

An entity should recognize revenue over time only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation (see further discussion below). A performance obligation that does not meet the criteria above is satisfied at a point in time. Determining when control transfers will require a significant amount of judgment. Indicators that might be considered in determining whether the customer has obtained control of a good include:
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Proposed model The customer has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis. Measuring transfer of control over time A contractor should measure progress toward satisfaction of a performance obligation that is satisfied over time using the method that best depicts the transfer of goods or services to the customer. Methods for recognizing revenue when control transfers over time include: Output methods that recognize revenue on the basis of direct measurement of the value to the customer of the entity's performance to date (for example, units delivered, surveys of goods or services transferred to date, appraisals of results achieved). Input methods that recognize revenue on the basis of the entity's efforts or inputs to the satisfaction of a performance obligation (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities). The method selected should be applied consistently to similar contracts with customers. Once the metric is calculated to measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognized.

Current U.S. GAAP

Current IFRS

A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. There are two different approaches for determining revenue, cost of revenue, and gross profit, once a "percentage complete" is derived: the Revenue method and the Gross Profit method.

A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. IFRS requires the use of the Revenue method to determine revenue, cost of revenue, and gross profit once a "percentage complete" is derived. The Gross Profit method is prohibited.

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Proposed model The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if goods are transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Estimates to measure the extent to which control has transferred (for example, estimated cost to complete when using a cost-to-cost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method. Impact:

Current U.S. GAAP

Current IFRS

A&D entities will need to assess government and commercial contracts to determine whether control of the asset(s) being constructed transfers over time to the buyer. Government contracts commonly require highly customized engineering and production where the government specifies the design and function of the items being produced. The products and services often have only a single customer (the government) or require government approval to sell to other customers. Government contracts also commonly require progress payments and an unconditional obligation to pay in exchange for the government controlling any work in process. We believe that many A&D contracts with the U.S. Government will meet the criteria for continuous transfer of control due to these factors. Contracts with other government customers will require careful analysis to determine if control transfers over time. Commercial aerospace contracts also commonly include highly customized systems and components that are integrated with the aircraft design and unique to a specific aircraft model. Whether contracts for systems and components provided to commercial aircraft manufacturers result in transfer of the goods or services underlying the contract over time will be a matter of judgment depending on the nature of the product, the contract terms, and related facts and circumstances. The exposure draft allows both input and output methods for recognizing revenue. An entity should select the method that best depicts the transfer of control of goods and services. This requirement might result in a change from the method an entity uses today. Input methods should represent the transfer of control of the asset to the customer and should therefore exclude any activities that do not depict the transfer of control. The Gross Profit method of calculating revenue, costs of revenue, and gross profit based on the percent complete will no longer be acceptable under the proposed standard, which is a change from current U.S. GAAP and might result in a change in the calculation of revenue to recognize.

Key changes from the June 2010 Exposure Draft: The June 2010 exposure draft had limited guidance for determining whether control transferred over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to response to feedback that the original guidance was difficult to apply to service transactions.

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The boards also added the indicators of "risk and rewards of ownership" and "evidence of customer acceptance" to provide further guidance on when control transfers at a point in time.

Example #3 Transfer of control over time


Facts: A contractor enters into a contract with a government to build an advanced radar and weapons system. The contract has the following characteristics: The radar and weapons system is designed to the government's specifications that, due to the proprietary technology used, cannot be transferred to any other government or customer without approval Non-refundable, interim progress payments are made by the government to the contractor The government can terminate the contract at any time, but is required to pay for work performed; the government has a lien on work in process Physical possession and title do not pass to the government until completion of the contract The contractor determined that the contract is a single performance obligation as they are providing a service to integrate all elements of the project into a single item for the government. How should the contractor recognize revenue in this example? Discussion: The contractor is providing a service that is satisfied over the contract term. The government controls the work in process as they have the obligation to pay for work performed, and any work performed is controlled by the government in the event of a contract termination. The contractor will therefore recognize revenue as the performance obligation is satisfied over time.

Example #4 Transfer of control at a point in time


Facts: A manufacturer enters into a contract with an airline to build a commercial aircraft. The manufacturer produces several aircraft models and each can be customized based on a customer's needs. The airline orders a standard model and selects certain options to customize the interior for items such as the seating configuration, entertainment system, etc. The customization will be performed by the manufacturer, but could also be performed by other vendors. The contract has the following characteristics: The airline is required to make progress payments over the period of production. These payments are refundable in the event of a cancellation. The airline can cancel the contract at any time and any work in process remains the property of the manufacturer. Title to the "green aircraft" transfers upon completion of the airframe and the manufacturer has a right to payment for the airframe. Physical possession of the aircraft does not pass to the airline until completion of the contract. The completion services are performed by the manufacturer once the airframe is completed. The manufacturer determined that the contract has two performance obligations: the base aircraft (or "green aircraft") and the completion services as the customer can benefit from the good or service on its own or with resources readily available to it (for example, others can perform the completion services). How should the manufacturer recognize revenue in this example?

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Discussion: The manufacturer should recognize revenue for the "green aircraft" when the airline obtains control of the aircraft, which in this case is likely upon transfer of title. The airline can direct the use and further completion of the aircraft, once the title transfers. Revenue would not be recognized as the aircraft is built as the criteria for satisfying a performance obligation over time would not be met because: The airline does not control the asset during construction. The asset does have an alternative use to the manufacturer as the base aircraft model is sold to other customers. Any rework to resell the asset is likely not significant in relation to the overall cost of the aircraft and therefore the aircraft could readily be directed to another customer. If the customer-specific costs are significant such that the manufacturer could support there was no alternative use for the aircraft, the remaining criteria for continuous transfer would still likely not be met as: -

The airline does not simultaneously receive and consume the benefits as the work is performed as the equipment is not usable until complete. Another entity would need to reperform the tasks performed to date as they would not have the benefit of the work in process of the manufacturer due to the nature of the asset and The manufacturer does not have a right to payment commensurate with the work performed. The progress payments received are refundable except for termination penalties that are unlikely to compensate the manufacturer A at an amount commensurate with the work performed on the aircraft.

The manufacturer should recognize revenue for the completion services as the services are performed. This performance obligation is being satisfied over time since the airline controls the work in process as they have title to the airframe being customized. The facts and circumstances of these types of arrangements will need to be carefully assessed and significant judgment could be required to determine the appropriate number of performance obligations and the method of revenue recognition.

Contract costs
Existing construction contract guidance contains a substantial amount of cost capitalization guidance, both related to precontract costs and costs to fulfill a contract. The proposed standard also includes contract cost guidance that could result in a change in the measurement and recognition of contract costs as compared to today (in particular for those contractors that use the gross profit percentage-of-completion method). Proposed model Incremental costs of obtaining a contract should be capitalized if the costs are expected to be recovered. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained (for example, sales commissions). Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. Current U.S. GAAP There is a significant amount of detailed guidance relating to the accounting for contract costs within the construction contract guidance. This is particularly true with respect to accounting for pre-contract costs. Current IFRS There is a significant amount of detailed guidance relating to the accounting for contract costs.

Costs that relate directly to a contract and are incurred in securing the contract are included as part of Pre-contract costs that are incurred for contract costs if they can be separately a specific anticipated contract generally identified, measured reliably, and it is may be deferred only if their probable that the contract will be recoverability from that contract is obtained. probable. Entities may recognize costs based on the average cost per unit, using estimates of total costs over the life of the contract. The average cost method

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Proposed model Direct costs incurred to fulfill a contract are first assessed to determine if they are within the scope of other standards (for example, inventory, intangibles, fixed assets), in which case the entity should account for such costs in accordance with those standards (either capitalize or expense). Costs that are not in the scope of another standard are evaluated under the revenue standard. An entity recognizes an asset only if the costs relate directly to a contract, relate to future performance, and are expected to be recovered under a contract. Costs that relate directly to a contract include costs that are incurred before the contract is obtained if those costs relate specifically to an anticipated contract. All costs relating to satisfied performance obligations and costs related to inefficiencies (that is, abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred. Capitalized costs are amortized as control of the goods or services to which the asset relates is transferred to the customer which may include specific anticipated contracts. Impact:

Current U.S. GAAP often results in the deferral of contract costs that are subsequently recognized as cost of sales as additional performance takes place under the contract.

Current IFRS

A&D entities that use the average cost method or otherwise defer costs under current guidance might be affected by the proposed standard. Entities will need to follow the hierarchy described in the proposed standard when capitalizing costs. Costs within the scope of another asset standard must be accounted for under that standard (which might require capitalization or expensing as incurred). This could result in more items being expensed than under today's guidance or the asset having a different useful life than the contract. Costs attributable to each performance obligation under the contract will generally be expensed as that individual performance obligation is satisfied. Application of the standard to learning curve costs will require significant judgment. Certain learning curve costs might meet the criteria for capitalization in the exposure draft. Demonstrating that learning costs relate to future performance obligations might be difficult and may result in some of those costs being expensed as incurred.

Key changes from the June 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the June 2010 exposure draft. The boards received feedback that certain costs to obtain a contract may meet the definition of an asset and should be capitalized. The guidance was therefore revised to permit recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered.

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The boards clarified that costs to fulfill are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of wasted materials, labor, or other resources that were not considered in the price of the contract should be recognized as an expense when incurred.

Example #5 Contract costs


Facts: A contractor enters into a contract to design and build a series of ten identical unmanned aircraft (a "low rate initial production" or "LRIP"). At the beginning of the contract, the contractor incurs certain mobilization costs amounting to $1 million to prepare for the production of the unmanned aircraft and $100,000 of costs for standard production parts. The mobilization costs include setting up the factory for production and non-recurring engineering on the production equipment. How should these costs be accounted for? Discussion: The cost of the standard production parts should be capitalized in accordance with existing inventory guidance. The mobilization costs might not be covered by existing asset standards (for example, inventory, fixed assets, or intangible assets), depending on the nature of those costs. Costs that are not covered by other standards are capitalized if they: (a) relate to the contract; (b) relate to future performance; and (c) are probable of recovery. Costs that meet these criteria should be capitalized and amortized over the contract period as control of the goods produced is transferred to the customer. The production set-up and non-recurring engineering costs likely meet these requirements and are capitalized, provided these costs are recoverable.

Example #6 Learning curve costs


Facts: A contractor enters into a contract to manufacture ten tanks for the government. The contractor determines based on the contract terms and nature of production that there is a single performance obligation in the contract due to the significant customization and integration required. The contract terms specify that any work in process is controlled by the government. The contractor estimates each tank will cost $80 million on average to manufacture and prices the contract at $90 million per tank or $900 million. The contractor previously developed the required technology to manufacture the tanks, but this is its first production contract. The first two tanks are expected to cost $95 million to manufacture due to the learning curve involved. How should the contractor record revenue and cost for this contract? Discussion: The terms of the contract result in control transferring over time to the government because the work in process is controlled by the government. Revenue should be recognized using an appropriate input or output measure. The contractor selects an input measure as the most appropriate measure of progress (for example, cost-to-cost) that results in the contractor recognizing more revenue and expense for the first tanks produced relative to the later tanks. This outcome would be appropriate due to the greater value of the entity's performance in the early part of the contract. The contractor would charge a higher price to a customer purchasing only one unit as compared to the average unit price when the customer purchases more than one unit.

Example #7 Learning curve costs


Facts: A contractor A enters into a contract to manufacture ten engines for a commercial aircraft manufacturer. The contractor determines based on the contract terms and nature of production that each engine is a separate performance obligation that is satisfied when each engine is delivered. The contractor estimates each engine will cost $3 million on average to manufacture and prices the contract at $5 million per engine. The contractor has previously developed the required technology to manufacture the engine, but this is its first production contract. The first engine is expected to cost $6 million to manufacture due to the learning curve involved. How should the contractor record revenue and cost for this contract?

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Discussion: The contractor should recognize revenue of $5 million when each engine is delivered and the customer obtains control. The contractor will need to assess whether the incremental $3 million of costs incurred to manufacture the first engine are eligible to be capitalized first under existing guidance (for example, inventory guidance) and then under the revenue guidance. Judgment will be necessary to determine if these incremental costs to produce the first engine relate to the satisfaction of future performance obligations (that is, completion of the remaining engines). Costs eligible to be capitalized under the revenue guidance would then be amortized over the current contract term and the term of specific anticipated future contracts.

Onerous performance obligations


Many A&D entities provide multiple services to their customers as part of a single arrangement, and may anticipate having losses on one performance obligation but an overall profitable contract. Existing guidance for construction contracts under both IFRS and U.S. GAAP requires recording anticipated losses when they become evident. This assessment is made at the contract level and measured based on the estimated contract revenue compared with the costs to complete the contract. The proposed standard requires assessing onerous losses at the performance obligation level for performance obligations satisfied over time and over a period of longer than one year. Proposed model Performance obligations satisfied over time (and over a period of greater than one year) are assessed to determine if they are onerous. Performance obligations satisfied at a point in time are not subject to this assessment in the proposed standard. A performance obligation is onerous if the transaction price allocated to the performance obligation is lower than the cost of settling the performance obligation. The cost of settling a performance obligation is the lower of: costs directly related to satisfying the performance obligation, or the amount the entity would pay to exit the performance obligation. The liability for an onerous performance obligation is measured as the excess of the cost to settle the performance obligation over the amount of consideration allocated to the performance obligation. Current U.S. GAAP Contracts within the scope of construction contract guidance are evaluated at the contract level. A loss provision is recorded if a contract is onerous. Current IFRS Contracts are evaluated at the contract level. A loss provision is recorded if a contract is onerous.

There is no specific guidance on how to measure a loss provision for contracts There is no specific guidance on how to which contain construction measure a loss provision for contracts deliverables and non-construction which contain construction deliverables. These contracts follow deliverables and non-construction general multiple-element arrangement deliverables. These contracts follow guidance. general multiple-element arrangement guidance. When there is a loss on the first element of an arrangement, but a profit When there is a loss on the first on the second element (and the overall element of an arrangement but a profit arrangement is profitable), an entity on the second element (and the overall may elect an accounting policy to arrangement is profitable), an entity recognize a loss upon delivery of the may elect an accounting policy to first element. Management should also recognize a loss if performance of the consider whether they have used the undelivered element is both probable most appropriate allocation method in and in the companys control. this situation. Specifically, there are two acceptable ways of treating the loss on the delivered element. The entity may: (a) recognize costs in an amount equal to the revenue allocated to the delivered unit of accounting and defer the remaining costs until delivery of the second element; or (b) recognize all costs associated with the delivered element (that is, recognize the loss) upon delivery of that element.

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Proposed model Impact:

Current U.S. GAAP

Current IFRS

Many contracts in the A&D industry will have a single performance obligation due to the promised bundle of goods or services being significantly customized and highly interrelated and the contractor providing a significant service of integrating the goods or services into the combined item(s). These contracts will likely not be affected by the proposed guidance because the onerous assessment will effectively be done at the contract level, similar to todays assessment, if there is only one performance obligation in the contract. Contracts with multiple performance obligations could be affected as there is a possibility that more onerous losses will be recognized under the proposed standard given that entities will need to make such assessments at the performance obligation level.

Key changes from the June 2010 Exposure Draft: The scope of the onerous test was modified to apply only to performance obligations that are satisfied over time and over a period greater than one year in response to concerns that the onerous test could have unintended consequences.

Long-term maintenance contracts


Long-term maintenance contracts are common within the industry. The accounting for such contracts is similar to extended or separately priced warranties and requires that an estimate be made of the number and nature of maintenance events that will occur over the contract period. Entities will need to consider the terms of the arrangement to determine if the discrete maintenance events are individual performance obligations under the proposed standard or if the arrangement is a single performance obligation satisfied over time. Proposed model Warranties that the customer does not have the option to purchase separately from the entity should be accounted for in accordance with existing guidance on product warranties (that is, as a cost accrual). Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. These types of extended maintenance and warranty contracts can include "power by the hour" contracts, which are common in the industry. A warranty that calls for a service to be provided to the customer (for example, maintenance) in addition to a promise that the entitys past performance was as specified in the contract results in a separate performance obligation for the service element of the warranty. Current U.S. GAAP Entities typically account for warranties that protect against latent defects in accordance with existing loss contingency guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Warranties that a customer can purchase separately are similar to many extended warranty contracts. Revenue from extended warranties is deferred and recognized over the expected life of the contract. Entities generally estimate the total expected costs to maintain the product over the performance period, and recognize the related revenue in proportion to the costs incurred to maintain the product. Current IFRS Entities typically account for warranties that protect against latent defects in accordance with existing provisions guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Warranties that a customer can purchase separately are similar to many extended warranty contracts. Revenue from extended warranties is deferred and recognized over the period covered by the warranty. Entities recognize revenue using the percentage of completion method. Input methods may be used, such as estimating the total expected costs to maintain the product over the performance period, with revenue recognized in proportion to the costs incurred to maintain the product.

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Proposed model Impact:

Current U.S. GAAP

Current IFRS

Similar to existing guidance, extended warranties or maintenance agreements give rise to a separate performance obligation under the proposed standard and therefore, revenue related to that performance obligation is recognized over the warranty period. Product warranties that are not sold separately and provide for defects at the time a product is shipped will result in a cost accrual similar to today under the current contingency or provisions guidance. Judgment will be needed to determine whether a long-term maintenance arrangement represents a single performance obligation satisfied over time or multiple discrete performance obligations, each satisfied when the maintenance event occurs. Contracts to perform an unspecified number of maintenance events over a period of time are likely to result in a single performance obligation satisfied over time. Contracts to perform each maintenance event at a specified price per event are likely to result in separate performance obligations for each maintenance activity.

Key changes from the June 2010 Exposure Draft: The boards revised the guidance from the June 2010 exposure draft on the two types of warranties, and clarified that only those warranties that provide a service or that the customer has the option to purchase separately should be accounted for as separate performance obligations. The boards also provided additional guidance on performance obligations satisfied over time, which will likely apply to many performance obligations for warranties.

Example #8 Long-term maintenance agreement


Facts: A company enters into a contract to sell an aerospace component system to a customer, and agrees to maintain that system for a period of 10 years once the system is placed in operation. These systems are often sold in the market without the extended maintenance contract and the maintenance contract can also typically be purchased for an additional cost. How should the company record revenue for this contract? Discussion: There are likely two performance obligations in this contract: one to deliver the aerospace component system and a separate performance obligation for the extended maintenance. The fact that the maintenance could be purchased separately by the customer would cause the maintenance to be a separate performance obligation. The total contract consideration should be allocated to the two performance obligations based on their relative standalone selling prices. The aerospace component system would likely be a performance obligation for a product satisfied at a point in time, with revenue recognized when control of the product is transferred to the customer. The maintenance performance obligation would likely be satisfied over time, with revenue recognized based on an appropriate measure of progress. <continued on next page>

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Other considerations
Proposed model Award and incentive fees Awards/incentive payments are included in the transaction price using either a probability-weighted approach or an estimate of the most likely amount of expected cash flows approach (whichever is more predictive). These amounts are recognized as revenue as the entity satisfies its related performance obligations, provided the entity is reasonably assured to be entitled to the amount allocated to that performance obligation. An entity is reasonably assured to be entitled to variable consideration when the contractor has experience with similar types of contracts and that experience is predictive (that is, that experience is relevant to the contract). Claims Claims should be included in contract consideration, using either a probability-weighted or most likely amount approach (whichever is more predictive). These amounts are recognized as the entity satisfies its related performance obligations, provided the entity is reasonably assured to be entitled to the amount allocated to that performance obligation (see above). Time value of money Contract revenue should reflect the time value of money whenever the contract includes a significant financing component. Management will use a discount rate that reflects a separate financing transaction between the entity and its customer that also factors in credit risk. An entity is not required to reflect the time value of money in the transaction price when the period between payment by the customer and the transfer of goods and/or services is less than one year, as a practical expedient. Receivables are discounted in limited situations, including receivables with payment terms longer than one year. The interest component is computed based the stated rate in the agreement or on a market rate when discounting is required. Receivables are discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate is used to determine the amount of revenue recognized as well as the interest income recorded over time. A claim is recorded as contract revenue when it is probable and can be estimated reliably (determined based on specific criteria), but only to the extent of contract costs incurred. Profits on claims are not recorded until they are realized. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured. Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Awards/incentive payments are included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Current U.S. GAAP Current IFRS

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Proposed model Impact:

Current U.S. GAAP

Current IFRS

Use of a most likely or probability-weighted estimate approach to determine the transaction price in arrangements involving bonuses, claims, and award fees may provide results similar to today when estimating the contract price under the construction contract guidance. Variable consideration can only be recognized when an entity is reasonably assured of being entitled to the amount, which is determined based on an entity's experience if that experience is predictive. This guidance could provide results similar to today's accounting, which provides for the estimation of variable amounts in the contract price. The assessment of when a contract has a significant financing component will require judgment. Contract terms often contain provisions for the contractor to receive progress payments as work progresses. Progress payments received that are commensurate with the progress toward completion generally would indicate there is not a significant financing component in the contract.

Key changes from the June 2010 Exposure Draft: There are three key changes impacting the A&D industry from the June 2010 exposure draft. First, in determining the consideration a contractor expects to be entitled to, entities may use a most-likely amount approach if such approach is more predictive than a probability-weighted estimate approach. The boards introduced a constraint on recognition of variable consideration to when the entity is reasonably assured of being entitled to the amount. A practical expedient was also introduced to limit the application of time value of money to situations where a significant financing component exists in the contract and the period between payment and the transfer of the promised goods or services is greater than one year.

Example #9 Award fees


Facts: A contractor enters into a contract for the development and build of a complex satellite system for the government. The contract price is $250 million plus a $25 million award fee if the system is placed into orbit by a specified date. The contract is expected to take three years to complete. The contractor has a long history of developing similar satellite systems. The award fee is binary and payable in full upon successful launch of the satellite. The contractor will receive none of the $25 million fee if the launch is unsuccessful. The contractor believes, based on significant experience with similar programs, that it is 95 percent likely that the contract will be completed successfully and in advance of the target date. How should the contractor account for the award fee? Discussion: The contractor is likely to conclude, given the binary award fee, that it is appropriate to use the most likely amount approach in determining the amount of variable consideration to include in the estimate of the transaction price. The contract's transaction price is therefore $275 million: the fixed contract price of $250 million plus the $25 million award fee (most-likely amount). This estimate is regularly revised and adjusted, as appropriate, using a cumulative catchup approach, which is consistent with current practice. The contractor will then determine when it is reasonably assured of being entitled to the award fee (and therefore, it is eligible to recognize this amount as revenue). Factors to consider include, but are not limited to: The contractor has a long history of performing this type of work on similar programs It is largely within the contractor's control to complete the work before the targeted date

This should not result in a significant change from todays accounting for variable consideration in many A&D contracts. The contractor could likely conclude in these circumstances that it is reasonably assured of being entitled to the award fee based on its history with similar contracts.
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Example #10 Claims


Facts: Assume the same fact pattern as Example 9, except that due to reasons outside of the contractor's control (for example, customer-caused delays and design changes), the cost of the contract far exceeds original estimates (but a profit is still expected). The contractor submits a claim against the government to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with the government. How should the contractor account for the claim? Discussion: Claims are highly susceptible to external factors (such as the judgment of third parties), and the possible outcomes are highly variable. The contractor may have experience in successfully negotiating claims, but it might be challenging to assert that such experience has predictive value in this fact pattern (because of the highly uncertain variables). The contractor might therefore conclude that it is not reasonably assured of being entitled to such a claim in the early stages. The amount of the claim is included in determining the transaction price, but will not be recognized until the contractor is reasonably assured of being entitled to the amount. The effect for performance obligations satisfied over time is that the claim amount is excluded from the calculation of revenue when the measure of progress towards completing the performance obligation is applied. Amounts from claims are likely to be recognized at a date closer to the date the claim is expected to be resolved.

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Authored by:
Scott Thompson U.S. Aerospace & Defense Leader Phone: 1-703-918-1976 Email: scott.thompson@us.pwc.com Daniel Dipillo Senior Manager Phone: 1-703-918-1415 Email: daniel.c.dipillo@us.pwc.com Craig Robichaud Senior Manager Phone: 1-973-236-4529 Email: craig.r.robichaud@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

US GAAP Convergence & IFRS Revenue recognition: Asset management industry supplement

Dataline A look at current financial reporting issues


No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Variable consideration management and performance fees ......... 2 Upfront fees received by an asset manager .............. 4 Fees paid to third parties ........................... 5 Other considerations .......7

Revenue recognition exposure draft The proposed revenue standard is re-exposed


Asset management industry supplement
Overview
The asset management industry comprises entities involved in management of various investment structures aimed at achieving returns for investors. Currently, under U.S. GAAP and IFRS, asset managers recognize revenue based on the transfer of risks and rewards of their services or based on the stage of completion of services. Under the proposed standard, revenue is recognized when the performance obligation is satisfied and the asset manager is reasonably assured it is entitled to the consideration. The current U.S. GAAP and IFRS guidance on revenue recognition will be withdrawn when the proposed standard becomes effective resulting in changes with respect to how revenue is recognized in the asset management industry. Common revenue streams in scope of the proposed standard are management fees, performance fees and upfront fees. The proposed standard also encompasses guidance relating to expense recognition, such as costs to secure and fulfill an asset management contract and so-called onerous performance obligations. This industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact. The examples and the related assessments contained herein are based on a current interpretation of the exposure draft, Revenue from Contracts with Customers, issued on November 14, 2011. The tentative conclusions set forth below are subject to further interpretation and assessment based on the final standard. The effective date of the final standard has not been determined, but it is expected to be no earlier than January 1, 2015 with retrospective or limited retrospective application required. Early adoption is permitted under IFRS whereas under U.S. GAAP early adoption will not be permitted. For a more comprehensive description of the proposed standard, refer to PwC Dataline 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org or www.ifrs.org.

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Variable consideration - management and performance fees


The transaction price is the consideration the asset manager expects to receive in exchange for satisfying its contractual performance obligations to the investor. The performance obligation in the asset management industry is the delivery of asset management services to the investor. This performance obligation is satisfied over time, as asset management services are delivered. Management must determine the amount of the transaction price at contract inception and at each reporting date. The entity will recognize revenue as the performance obligation is satisfied. The asset manager is reasonably assured to be entitled to the transaction price when it has experience with similar contracts (either its own experience or that of others, if applicable) and that experience is relevant to the contract because circumstances are not expected to change significantly. Management fees for hedge funds and mutual funds are usually based on net assets under management, while performance fees are usually based on profits generated from the underlying investments held by funds subject to certain thresholds (for example, hurdle rate, high watermark or internal rate of return). As such, management fees and performance fees constitute what is referred to in the proposed standard as variable consideration. The table below summarizes the proposed guidance for variable consideration in comparison to current U.S. GAAP and IFRS guidance. Proposed standard Management and performance fees If the promised amount of consideration in a contract is variable, the asset manager should estimate the total amount to which it will be entitled in exchange for transferring promised services. The estimated transaction price should be updated at each reporting date to represent the circumstances present at the reporting date and the changes in circumstances during the reporting period. Current U.S. GAAP Management fees: A base management fee is earned periodically for providing asset management services, typically based on a fixed percentage of the fair value of the net assets under management. These fees are generally accrued periodically in accordance with the terms of the asset management contract. Current IFRS Management fees: A base management fee is earned periodically for providing asset management services, typically based on a fixed percentage of the fair value of the assets under management. These fees are generally accrued periodically in accordance with the terms of the asset management contract. Performance fees: Two approaches are permitted. Under the first approach, noncontingent and contingent fees are analyzed separately. Performance fees, being contingent amounts of revenue, are recognized as the services are performed but only when the fee becomes reliably measurable, which is often at the end of the performance period when the outcome is known. Under the second approach, an asset manager looks at the contract as a whole and recognizes revenue based on the performance to date, including an estimate of any performance fees due. Estimates are periodically reassessed.

Performance fees: Performance fees can be recognized The transaction price is estimated using one of two methods under the based on a probability-weighted or best current guidance for management fees estimate approach depending on which based on a formula1 due to the fact that is most predictive for the entity based they are based on profits earned on historical, current and forecasted subject to performance targets (for information. example, high watermark or hurdle rate) and may be subject to clawback. The asset manager should recognize as revenue the amount of the transaction Under Method 1, performance fees are price allocated to the performance recognized in the periods during which obligation if it is reasonably assured to the related services are performed and be entitled to that amount. Revenue all the contingencies have been might not be reasonably assured when resolved: the amount of consideration is highly susceptible to factors outside the for hedge fund managers, this influence of the asset manager or the occurs at the end of the year or uncertainty about the amount of upon the occurrence of the consideration is not expected to be crystallization event; resolved in the near future. Another

The guidance for accounting for management fees based on a formula is included in ASC 605-20-S99-1 (formerly EITF D-96).

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Proposed standard indication of revenue not being reasonably assured might be that the asset managers experience with similar types of contracts is limited or the contract has a large number and high variability of possible consideration amounts.

Current U.S. GAAP for private equity fund managers, this occurs upon termination of the fund or when distributions from a fund exceed the point at which the clawback of a portion or all of the historic performance fees distributions could no longer occur. Method 2 requires performance fee revenue to be recorded at the amount that would be due under the contract at any point in time as if the contract was terminated at that date (otherwise known as the hypothetical liquidation method). As a result, there is a possibility that fees earned by exceeding performance targets early in the measurement period could be reversed due to missing performance targets later in the measurement period. The SEC views Method 1 as the preferable accounting policy.

Current IFRS

Management fees
The proposed standard provides an example of a management and performance fee arrangement commonly encountered in the asset management industry. The performance obligation in this example is to provide asset management services and the asset manager will estimate the transaction price to be the sum of the estimated periodic management fees and performance-based fees. That transaction price is allocated to the performance obligation that the entity satisfies over the period specified in the contract. Management should determine the pattern of transfer of the asset management service (using input or output methods), which governs the amount of revenue recognized in each period under the proposed standard. Management should assess the pattern of transfer for performance obligations satisfied over multiple periods (for example, on a quarterly basis). The pattern of transfer might be similar to the amount of consideration otherwise due and receivable each period. This would be the case if the assets under management are representative of the level of asset management service transferred to the investor. The amount of fee that is due and receivable for a period would then also represent the amount to be recognized for the period. We believe that in many circumstances, analysis of the pattern of transfer of asset management services will result in recognition of revenue related to periodic management fees based on assets under management in a manner that is consistent with current practice under both U.S. GAAP and IFRS.

Performance fees
The proposed standard may impact the timing of the recognition of performance fees, as variable consideration is only recognized when the asset manager is reasonably assured of being entitled to the consideration. It may often be the case that asset managers will be unable to conclude that they have met the "reasonably assured" threshold and therefore, will not be able to recognize the variable consideration before the performance period has ended (which may include any subsequent clawback periods). This is because performance-based fees may be highly susceptible to external factors such as market risk.

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The contractual measurement period for performance fees for hedge fund managers and traditional fund managers is usually one year and therefore, no fees will be recognized in the interim periods (for example, at the end of each quarter). The full amount will instead be recognized at the end of the contractual measurement period when the manager becomes reasonably assured to be entitled to that amount. The fees will be recognized upon a crystallization event (for example, redemptions), in certain cases, because the amount becomes fixed and therefore, the entity is reasonably assured to be entitled to the amount. Managers of funds with a finite life (for example, ten years) often receive performance fees subject to clawback on a cumulative basis based on the performance of the fund over its life. Any distributions of performance fees that could potentially be subject to clawback in future periods will be reflected as deferred revenue until the point at which the entity is reasonably assured to be entitled to retain the amount received. Cash receipt of performance fees does not necessarily indicate that the entity is reasonably assured to be entitled to that amount. For example, an entity might not be reasonably assured to be entitled to performance fees that are subject to clawback until a point in time toward the end of the life of the fund. Under current U.S. GAAP, asset managers applying Method 1 are, in light of the above, not expected to be significantly affected by the proposed standard. On the other hand, asset managers that currently recognize performance fees in accordance with Method 2 (hypothetical liquidation method) will be impacted since entities applying this method may be recognizing revenue in advance of the amount becoming reasonably assured as defined under the proposed standard. Under current IFRS, asset managers will generally not be significantly impacted by the proposed standard as the prevalent IFRS practice is to recognize performance fees when the performance fee becomes reliably estimable and the amount is known. However, asset managers currently recognizing performance fees using the second approach will recognize revenue only when the performance fee is reasonably assured, which is likely to result in later revenue recognition.

Upfront fees received by an asset manager


Asset managers may own a broker or distribution entity that distributes the asset managers sponsored products (or, in some cases, the asset manager might distribute the sponsored products directly). When distribution is done by the asset manager directly or through a distribution entity that is consolidated by the asset manager, the issue of revenue recognition for upfront fees becomes relevant. (This section does not address the accounting in the broker or distribution entity's standalone financial statements.) Upfront fees are generally associated with front-end loaded distribution. Front-end loaded distribution means that an initial sales fee is paid by the investor to the distribution entity upon subscription to the fund (that is, the investor bears the fee on the front end"). This fee compensates the distribution entity, with the subscription amount net of such fee being contributed to the fund. Relevant guidance under the proposed standard, current U.S. GAAP and IFRS is summarized below: Proposed Standard Current U.S. GAAP Current IFRS Initial sales fees are generally recognized as revenue when received only to the extent that services have been provided and the fees do not relate to future services. The receipt of the initial sales fee does not by itself provide evidence that all services associated with that fee have been provided or that the fair value of the services provided in respect of any upfront services is equal to the initial sales fee received.

The proposed standard requires the Initial sales fees are generally asset manager to assess whether the fee recognized as revenue upon receipt. relates to a separate performance obligation The proposed standard further recognizes that in many cases, even though a nonrefundable upfront fee relates to an activity that the asset manager is required to undertake at or near contract inception to fulfill the contract, that activity does not result in the transfer of a promised service to the investor. Rather, the upfront fee is viewed as an advance payment for future services and therefore, would be

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Proposed Standard recognized as revenue when those future services are provided.

Current U.S. GAAP

Current IFRS If the fee is linked to other services or obligations (for example, as evidenced by a fee that is not at fair value for those individual services or the pricing is only understood with reference to services to be performed in the future), the revenue that corresponds with this part of the fee is deferred and recognized as those services are performed. Initial sales fees are typically deferred and spread over the period that the investor is expected to remain with the fund being managed.

As stated above, under the proposed standard, initial sales fees can only be recognized upfront if a distinct service has been provided to the investor upon the initial sale of the fund unit. This will be very difficult to demonstrate in most cases. Therefore, asset managers need to consider what other services are being provided to the investor (for example, ongoing management services or brokerage services) in order to identify services that are distinct. The transaction price, including the initial sales fees, is then allocated to each of the distinct services and recognized as each is being provided to the investor. Typically, even though the initial sales fee relates to an activity that the asset manager is required to undertake at the inception of the contract, it does not result in the transfer of a promised service to the investor. As such, there is only one performance obligation in the arrangement, and asset managers reporting under U.S. GAAP will no longer be able to recognize revenue upfront for these fees. The initial sales fee will instead be deferred and recognized over the estimated period the investor is expected to remain with the fund, which conforms to current practice utilized by IFRS preparers. In the brokers standalone financial statements, the broker will recognize an upfront fee when the service is performed. The service is performed at a point in time (that is, upfront) as the service provided is to introduce an investor to the fund.

Fees paid to third parties


Often asset managers pay fees to third parties that distribute the asset managers' products. Various types of fees are paid, and the timing of payment may also vary (that is, the fees may be paid upfront or on an ongoing basis). The third party generally does not provide substantive ongoing services in addition to the initial introduction of the investor to the fund. One example of a fee paid to a third party is deferred sales commissions. Such a fee is paid by the asset manager of certain registered funds to a third-party broker in connection with back-end loaded distribution. Specifically, the asset manager agrees to compensate the broker for the fixed initial sales fee and the investor does not bear cost of any commission initially. The asset manager recovers the initial sales fee through charges levied over the asset management period and may also charge a fee by reference to the initial subscription amount should the investor withdraw from the fund. Another example is third-party marketer fees (sometimes referred to as trailing commissions). Third-party marketers are used by asset managers of hedge funds and registered funds to introduce investors to the fund being managed. The third-party marketer earns a percentage of the upfront fee and the subsequent management fees charged to the investors that it attracted to the fund. This may extend for the period that the investor remains in the fund. Asset managers of private equity funds may also incur placement fees paid upfront to underwriters to secure capital commitments for the fund. Such fees are paid by the asset manager once the contract is obtained and calculated based on the capital commitment from each investor. Third-party fee arrangements such as those described above represent contract costs (that is, costs incurred in conjunction with obtaining the revenue-generating contract). The associated guidance for these costs is as follows:
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Proposed Standard An asset manager will recognize as an asset the incremental costs of obtaining a contract with an investor if it expects to recover those costs. The incremental costs of obtaining a contract are those costs that the asset manager would not have incurred if the contract had not been obtained (for example, a sales commission).

Current U.S. GAAP In accordance with industry practice, deferred sales commissions (that is, fixed fees) paid to the third-party distributor are generally recognized as an asset and amortized over the period of contractual redemption, which can range from a few months to several years.

Current IFRS Fixed fees paid that are incremental and directly attributable to securing an investment contract are capitalized if they can be identified separately, measured reliably, and it is probable that they will be recovered.

An incremental cost is one that would not have been incurred if the entity Impairment is recognized if the asset had not secured the investment An asset recognized in accordance is not recoverable, based on a management contract. The asset is with the above is amortized on a determination of the asset's fair value. amortized as the asset manager systematic basis consistent with the recognizes the related revenue. pattern of transfer of the services to Third-party marketer fees (also which the asset relates. The known as "trailing commission") are If the carrying value of the capitalized incremental costs can be recognized expensed as incurred, which mirrors asset exceeds the recoverable amount, as an expense when incurred if the the way the management fee is the asset is impaired and an amortization period is less than a year recognized. impairment loss is recognized. as a practical expedient. Placement fees are expensed as There are currently two permissible An impairment loss is recognized to incurred. approaches to account for ongoing the extent that the carrying amount of third-party fee arrangements such as the capitalized asset exceeds the net third party marketer fees (also known amount of consideration to which the as "trailing commissions") entity expects to be entitled in exchange for the services to which the The first approach treats the asset relates, less the remaining costs arrangement as a financial liability, that relate directly to providing these initially measuring the obligation to services. pay the fees at fair value. Subsequently, the asset manager will account for the financial liability at amortized cost using the effective interest method. Under the second approach, the ongoing third-party fees should be accounted for when the contingent fee payable becomes due to the third party (that is, expensed as incurred). Both approaches are used, although typically the industry practice is to account for trailing commission fees using the second approach. Placement fees are generally capitalized under financial instruments guidance or, if not related to the issuance of securities, capitalized as costs of securing investment contracts.

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In the proposed standard, it is important to clearly distinguish between costs to fulfill a contract and incremental costs to obtain a contract. Whereas the former are first evaluated under other applicable existing guidance such as guidance for intangible assets or property, plant and equipment, the latter are only governed by the proposed standard. If costs are incurred by the asset manager in its efforts to obtain a contract with an investor and such costs would not have been incurred if the asset manager had not obtained the contract, and the costs are expected to be recovered, these costs must be capitalized unless the amortization period is less than a year. If the amortization period is less than a year, the incremental costs can be recognized as an expense when incurred as a practical expedient. Costs do not need to be explicitly reimbursable to be recoverable.

Incremental fixed fees paid upfront (such as deferred sales commissions)


U.S. GAAP preparers will continue to account for deferred sales commissions as assets as such costs would appear to meet the proposed standard's asset recognition criteria. However, the amortization period will change from the contractual redemption period to reflect the pattern of transfer of asset management services (that is, the period that the investor is expected to remain invested in the fund). This would result in costs being amortized over a longer period than under current U.S. GAAP. IFRS preparers will find that the proposed guidance as it relates to deferred sales commissions results in an accounting treatment similar to current practice and therefore, no significant impact is expected from applying the proposed standard. There will, however, be a difference between current practice and the proposed standard with respect to impairment of the capitalized fees. Under current guidance, discounted cash flows are used in the test for impairment whereas under the proposed standard, the same principles that are used to determine the transaction price would be followed, which could result in using undiscounted cash flows.

Third-party marketer fees (known as "trailing commissions")


When no ongoing services are provided after the initial introduction of the investor, third -party marketer fees would appear to meet the definition of costs of obtaining a contract and therefore, need to be capitalized when the service has been received unless the amortization period would have been for less than one year and the practical expedient is elected. This accounting treatment does not conform to current industry practice under either U.S. GAAP or IFRS, as such fees are typically expensed as incurred. A question then arises as to the amount of third-party marketer fees to be capitalized as the fee due to the third-party marketer only becomes known at the point in time when the management fee is contractually due (for example, the beginning or end of a month/quarter). The cost is therefore variable. The proposed standard does not specifically address this issue. Therefore, management will need to develop a reasonable and practical approach as to the capitalization and amortization of these fees.

Placement fees
Placement fees paid by the asset manager upfront to underwriters to secure capital commitments for the fund would meet the definition of costs of obtaining a contract. Therefore, such fees need to be capitalized when the service has been received unless the amortization period would have been for less than one year and the practical expedient is elected. This accounting treatment does not conform to current industry practice under U.S. GAAP, under which placement fees are typically expensed as incurred. Under IFRS, some of these fees might be accounted for under financial instrument guidance (and may therefore not be impacted by the proposed standard) and others might be accounted for as costs to acquire a contract. When accounted as costs to acquire a contract, the treatment should be consistent with current practice. For private equity fund managers, where the fund is limited life, placement fees would be amortized over the life of the fund (for example, ten years) under the proposed guidance. For hedge fund managers, the amortization term is the period the investor is expected to remain in the fund.

Other considerations
This asset management industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact. Other considerations include the following: Onerous performance obligations - Onerous performance obligations guidance was not previously explicitly addressed by U.S. GAAP; however, onerous losses are expected to be uncommon due to the nature of the arrangements that are typical in the asset management industry. It is noteworthy that under the proposed standard, asset managers will be able to include both management fees and estimated performance fees to be received over the

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life of the contract when determining total estimated fees (that is, total transaction price). These amounts would typically be sufficient to cover direct expenses attributable to the asset management contract (for example, incremental cost of labor, upfront placement cost and other incremental operational expenses) and therefore, would not trigger onerous contract accounting. Nevertheless, asset managers will need to consider whether an asset management contract with an investor is onerous, particularly in falling markets when fees may be decreasing but elements of costs may be fixed. Employee "points" compensation - Some asset managers award their key employees with points compensation whereby these employees receive a specified percentage of crystallized performance fees earned by the manager. The compensation expense resulting from such arrangements is currently estimated and accrued under both U.S. GAAP and IFRS. At each reporting date, asset managers that currently apply Method 2 under U.S. GAAP or the second approach under IFRS are therefore able to match the compensation expense with the associated performance fee income. Under the proposed standard, however, a mismatch will arise as the compensation expense will continue to be accrued whereas the performance fee income will be recognized when the manager is reasonably assured to be entitled to the amount (as more fully described above) and therefore may be in a different period. Systems and processes - As the standard is expected to be effective no earlier than 2015 with retrospective application required, asset managers that currently recognize performance fee using Method 2 under U.S. GAAP or the second approach under IFRS as described above should assess process and systems implications as early as the end of 2012 to capture the information needed for retrospective application when the final standard is adopted. Investor relations - Asset managers that recognize performance fees in accordance with Method 2 under U.S. GAAP or the second approach under IFRS may experience significant changes with respect to how they report their results of operations. These changes will need to be communicated to the investor community. Asset managers might also want to consider changes to their non-GAAP metrics to reflect, for example, changes in timing of recognition of performance fees.

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Authored by:
Thomas Romeo Partner Phone: 1-973-236-4460 Email: thomas.romeo@us.pwc.com Brett Cohen Partner Phone: 1-973-236-7201 Email: brett.cohen@us.pwc.com Marie Kling Partner Phone: 1-973-236-4460 Email: marie.kling@us.pwc.com Guilaine Saroul Director Phone: 1-973-236-7138 Email: guilaine.saroul@us.pwc.com Daniel Kramarz Senior Manager Phone: 1-646-471-5678 Email: daniel.x.kramarz@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

US GAAP Convergence & IFRS Revenue recognition: Automotive industry supplement

Dataline A look at current financial reporting issues


No. 2011-35 (supplement) December 16, 2011 Whats inside: Overview .......................... 1 Defining the contract ..... 2 Account for separate performance obligations .................... 4 Determine and allocate the transaction price.......... 6 Recognize revenue when performance obligations are satisfied ...................... 10 Other considerations ..... 13

Revenue recognition exposure draft The proposed revenue standard is re-exposed

Automotive industry supplement


Overview
The automotive industry includes a broad group of participants, including suppliers, original equipment manufacturers (OEMs), and dealers. Entities in the automotive industry will be affected by the proposed revenue standard, which will replace all current U.S. GAAP and IFRS revenue recognition guidance. Key areas of interest to companies in the automotive industry include the accounting for product warranties, pre-production activities (for example, pre-production design and tooling arrangements), marketing incentives (for example, cash rebates), volume rebates, repurchase options, contract costs, and lease financing arrangements. This automotive industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact or be of particular interest. The examples and the related assessments contained herein are based on a current interpretation of the exposure draft, "Revenue from Contracts with Customers," issued on November 14, 2011. All conclusions set forth below are subject to interpretation and assessment of the final standard, which is expected to be issued in the second half of 2012. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the "2010 Exposure Draft") throughout this industry supplement and in the Appendix of PwC Dataline 2011-35. References to the "proposed model," "proposed guidance," and "proposed standard" throughout this document refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard, refer to PwC Dataline 2011-35 (www.cfodirect.pwc.com), or visit www.fasb.org or www.ifrs.org.

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Defining the contract


The proposed standard would apply only to contracts with customers. A contract is an agreement between two or more parties that creates enforceable rights and obligations. A contract does not exist if both parties have the unilateral right to terminate a wholly unperformed contract without penalty. Entities will need to determine whether they should account for two or more contracts with the same customer together. Combining contracts when appropriate helps to ensure that the unit of accounting is properly identified, and the model is properly applied. For example, automotive suppliers often incur costs related to tooling prior to production of automotive parts. In some cases, the tooling is built by the supplier for sale to the OEM (that is, the tooling is or will be owned by the OEM). There is often a separate contract for both the construction of the tooling and the follow-on production output. Contract modifications are common in the automotive industry and come in a variety of forms, including changes in the amount of goods to be transferred and changes in previously agreed pricing. Contract modifications might need to be combined and accounted for together with the existing contract under the proposed standard. It is not uncommon, for example, for an entity to receive price concessions on existing contracts in connection with the negotiation of new contracts. The entity will need to evaluate whether a price concession is a modification of a previous contract or if it relates to a new contract. The entity might need to account for the price concession as part of the new contract and recognize the associated revenue as the performance obligations in the new contract are satisfied. Proposed model Combining contracts Two or more contracts (including contracts with parties related to the customer) should be combined and accounted for as one contract if the contracts are entered into at or near the same time and: The contracts are negotiated with a single commercial objective; The amount of consideration in one contract depends on the price or performance of the other contract; or The goods or services promised are a single performance obligation. Contract modifications A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the promised goods or services There is no clear guidance on accounting for contract modifications within the non-industry specific revenue guidance. We believe many entities account for contract modifications prospectively unless the contract modification is explicitly tied to prior performance. Non-refundable payments associated with accommodation arrangements (for example, price concessions) There is no clear guidance on accounting for contract modifications. Many entities account for contract modifications prospectively today unless the contract modification is explicitly tied to prior performance. Non-refundable payments associated with accommodation arrangements (for example, price concessions) might need to be linked to another arrangement in order to understand Combining contracts that are not in the scope of certain industry specific guidance (for example, construction accounting) is required if they are with the same or related entities and are negotiated at the same time. Combining contracts that are not in the scope of certain industry specific guidance (for example, construction accounting) is required when two or more transactions are linked and combination is necessary to reflect the commercial (that is, economic) substance of the transactions. Current U.S. GAAP Current IFRS

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Proposed model underlying that performance obligation.

Current U.S. GAAP

Current IFRS their commercial effects and should generally be deferred similar to the accounting for an upfront fee.

typically do not represent the culmination of a separate earnings process and should generally be A modification that is not a separate deferred similar to the accounting for contract is evaluated and accounted for an upfront fee. either as: A termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification A cumulative adjustment to contract revenue if the remaining goods and services are not distinct and are part of a single performance obligation that is partially satisfied A prospective adjustment to contract revenue when the remaining goods or services are a combination of distinct and nondistinct Potential Impact:

Although the identification of contracts is not expected to be particularly difficult, this step in the process could result in changes within the automotive industry. We anticipate that there will be certain contractual arrangements (for example, contracts for pre-production activities related to long-term supply arrangements) that might need to be considered together as a single contract, albeit as separate performance obligations, for accounting purposes (see discussion below regarding separately accounting for two or more performance obligations and allocating the transaction price). This determination could result in a change in the allocation and pattern of revenue recognition under the proposed standard compared to todays accounting. Contract modifications will continue to require judgment to determine when they should be accounted for as a separate contract. We do not expect current practice in this area to be significantly changed by the proposed standard.

Example 1 - Combining contracts (tooling and production contracts)


Facts: In January, a supplier enters into a contract with an OEM to construct a tool for the OEM. Ownership of the tool will transfer from the supplier to the OEM. Also in January, the supplier enters into a contract to provide the OEM with parts, which will be produced using the tool that is being constructed for the OEM. The supplier will recover the sales price for the tool through a separate payment at a contractually stated amount once the tooling is constructed and approved by the OEM. The contractually stated amount is the supplier's cost to provide the tooling. Production of the parts will begin once the tool has been constructed to the specifications agreed between the supplier and the OEM. Should the supplier combine the contract to construct the tool with the contract to produce the parts? Discussion: The supplier will need to consider a number of factors to determine whether these two contracts should be combined. In this example, the contracts were entered into near the same time. It is also likely that the contracts were negotiated with a single commercial objective, because the supplier is both constructing the tool and providing the production parts. Thus, we believe the supplier would likely combine these two contracts based on consideration of these factors.

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Example 2 - Contract modification


Facts: A supplier and an OEM have an existing contract for the sale of 1,000 parts at a price of $10. Total contract revenue under the existing contract would therefore be $10,000. The OEM purchases 500 parts at that price, then negotiates a price change from $10 to $7.50. The price change only relates to the remaining purchases and is based on the OEM's willingness to increase the volume of purchases to 1,500 parts. A similar discount is not offered on other parts manufactured by the supplier and sold to other OEMs. Should this contract modification be combined with the existing contract or accounted for as a separate contract? Discussion: As the remaining parts to be transferred to the OEM are distinct from the 500 transferred on or before the date of the modification, the supplier would account for the modification as a termination of the original contract and the creation of a new contract. The supplier would recognize revenue of $7.50 as control of each of the remaining 1,000 parts is transferred to the OEM.

Example 3 - Accommodation arrangement


Facts: A supplier and an OEM have an existing contract for the sale of parts at a price of $10. While the supplier expected the OEM to purchase 1,000 parts when entering into the contract, the OEM was under no obligation to purchase a minimum number of parts. The OEM only purchased 500 parts over the contract period due to lower than expected demand for its vehicle. At the end of the contract, the OEM agrees to a price concession of $5,000 ((1,000 parts expected 500 parts sold) x $10) in the form of a non-refundable payment to make up for the lower than expected volumes. The OEM was under no previous obligation under the original contract to agree to the price concession. At the same time the supplier negotiates a second contract with the OEM for parts to be delivered in the following year at a price of $10 based on the expectation that the OEM will purchase 1,000 parts over the second contract period. How should the supplier account for the non-refundable payment received? Discussion: The proposed standard is not clear, but we would generally expect the price concession to be treated as part of the consideration of the second contract in most cases and not a modification of the original contract. This is because the OEM had no previous obligation to agree to a price increase on the original contract and the price concession is negotiated at the same time as, and in contemplation of, the second contract. We expect in most cases that the non-refundable payment will be allocated as part of the transaction price under the second contract and revenue of $15 (($5,000 nonrefundable payment + (1,000 parts x $10)) / 1,000 expected parts) recognized as control of each part in the second contract is transferred to the OEM.

Account for separate performance obligations


The objective of identifying and separating performance obligations is to recognize revenue when the performance obligations are satisfied (that is, goods and services are transferred to the customer). An OEMs agreement to transfer a vehicle and to provide free maintenance on the vehicle, for example, would likely require separation. Contracts must be evaluated to ensure that all performance obligations are identified. Proposed model An entity should separately account for performance obligations only if the pattern of transfer is different and the good or service is distinct. A good or service is distinct if either of the following criteria are met: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with other readily available resources. Current U.S. GAAP Arrangements with multiple deliverables that are not in the scope of construction accounting are divided into separate units of accounting if the deliverables in the arrangement meet specific criteria. Separation is appropriate when the delivered item(s) has value to the customer on a standalone basis and the delivery of the undelivered item(s) is probable and substantially within the control of the vendor. Current IFRS For transactions that contain separately identifiable components, it is necessary to apply the revenue recognition criteria to each separately identifiable component of a single transaction in order to reflect the transaction's substance. The customer's perspective is important in determining whether the transaction has a single element or multiple elements.

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Proposed model An entity should account for two or more performance obligations as a single performance obligation when both of the following criteria are met: The goods or services are highly interrelated and the entity provides a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted. The bundle of goods or services is significantly modified or customized to fulfill the contract. Potential Impact:

Current U.S. GAAP

Current IFRS

The indicators for separation generally are expected to result in similar outcomes as under the current guidance in U.S. GAAP and IFRS. However, we expect that entities in the automotive industry might, in certain cases, need to separately account for more performance obligations under the proposed model than today. This may impact the timing of revenue recognition as compared to current accounting. If an entity concludes, for example, that separate contracts for the construction of a tool and for follow-on production parts should be combined, it is likely that the entity will then have to separately account for the obligation to construct the tool and the obligation to produce the parts. Certain warranties containing service elements will also likely result in more performance obligations under the proposed model as compared to today (refer to "Product warranties" section below).

Key change from the 2010 Exposure Draft: The boards have clarified the principle for when to separately account for performance obligations. They are now proposing to provide guidance for situations when it may be necessary to account for a promised bundle of goods or services as a single performance obligation. We believe entities might have to separately account for more obligations within each contract compared to current guidance, notwithstanding the additional guidance.

Example 4 - Identify the performance obligations (tooling and production contracts)


Facts: Assume from example 1 that the contract to construct the tool should be combined with the contract to produce the follow-on production parts. The supplier is one of several suppliers with the ability to construct the tool and subsequently produce the production parts. What are the separately accounted for performance obligations under the combined contract? Discussion: The supplier has promised to transfer both the tool and the subsequent production parts to the OEM. When an entity promises to provide more than one good or service, each promised good or service is a separate performance obligation if it has a different pattern of transfer and is distinct. The tool and subsequent production parts are likely to be separable because the supplier does not provide a significant service of integrating both into a combined item. The tool and the parts are distinct because they are delivered at different times and the OEM could benefit from the tool by taking it to another supplier and having that other supplier produce the subsequent production parts. The tool and the production parts would likely be separate performance obligations based on these considerations. The supplier will therefore recognize revenue for each distinct performance obligation based on its relative standalone selling price (refer to "Determine and allocate the transaction price" section below) when control of each asset is transferred to the OEM.

Example 5 - Identify the performance obligations (free maintenance)


Facts: A dealer offers a customer "free" vehicle maintenance for the first 3 years or 30,000 miles after taking delivery of a new vehicle, whichever comes first. The maintenance services are provided every 6 months or 5,000 miles. The
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maintenance is performed by the dealer as an agent on behalf of the OEM and the dealer is subsequently reimbursed by the OEM. Would this service be a separate performance obligation of the dealer or OEM? Discussion: These services could be separate performance obligations of the OEM that require separate accounting. This is because the contract to provide maintenance is legally between the OEM and the end customer. The pattern of transfer between the sale of the car to the dealer and performing the maintenance services is different, and the maintenance services are likely distinct. The OEM likely has six performance obligations for the free maintenance in this example (that is, one performance obligation for each distinct maintenance service that is promised in the contract). The OEM would recognize revenue as the maintenance is performed or when the time period lapses. We do not believe the pattern of revenue recognition will change significantly from current practice for many entities, as revenue is often recognized today based on a systematic and rational method that is aligned with the terms of the maintenance agreement.

Example 6 - Identify the performance obligations (technological amenities)


Facts: It is common for OEMs to sell vehicles equipped with various technological "amenities," such as satellite radio, navigation capabilities, or roadside assistance. These amenities may be provided by third-parties or directly by OEMs. Would these technological amenities be considered separate performance obligations of the OEM? Discussion: These amenities may be considered separate performance obligations of the OEM in certain circumstances under the proposed model. It is important to consider whether the OEM has a performance obligation, either explicit or implicit, to provide the underlying services to the end customer. This will be a matter of judgment and may be different depending on the specific terms of the arrangement. Consider, for example, satellite radio service provided by a third party. OEMs often sell vehicles in which the owner can receive satellite radio service for free for a trial period (for example, three months) when a consumer purchases a new vehicle. Generally OEMs enter into separate contracts with the third party satellite radio provider who is responsible for providing the satellite radio service to the end customer during the trial period. At the end of the trial period, any renewals are separate transactions between the third party satellite provider and the end customer. The OEMs obligation to the end customer is to provide a working radio with the ability to receive satellite radio stations. It is likely that this obligation will be considered part of the OEMs over all performance obligation to deliver a working vehicle, whereas the third party satellite radio service provider will need to separately consider its obligation to provide service to the end customer (that is, the service is likely not a separate performance obligation of the OEM). Determining the appropriate revenue recognition for these amenities will depend on the OEMs performance obligation.

Example 7 - Product liabilities


Facts: Entities in the automotive industry can, at times, be legally obligated to pay consideration to a customer if the entity's product causes harm or damage. Would these product liabilities be considered a performance obligation under the proposed standard? Discussion: Product liability obligations (for example, when an entity is legally obligated to pay consideration if its products cause harm or damage) are not performance obligations as there is no good or service being provided in an exchange transaction. The accounting for product liability claims will continue to be covered by existing guidance for loss contingencies and provisions.

Determine and allocate the transaction price


The transaction price is the consideration the entity expects to be entitled to receive in exchange for satisfying its performance obligations. The transaction price is readily determinable in most contracts because the customer promises to pay a fixed amount of cash that is due when the entity transfers the promised goods or services (for example, when a supplier sells parts to an OEM for a specified price payable when the parts are delivered). Determining the transaction price in other contracts can be more complex, such as contracts with stated price increases or decreases over time or with volume pricing adjustments. The transaction price allocated to performance obligations in an arrangement also includes consideration payable to the customer and the time value of money.

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OEMs and suppliers commonly offer various forms of customer incentives that reduce the transaction price. Two examples of incentives are cash rebates offered by OEMs and volume discounts offered by suppliers. Once the amount of consideration is determined, it must then be allocated to the separate performance obligations in the contract. We expect that entities might have to separately account for more performance obligations than today if the risks of providing two or more goods or services are not largely inseparable (as described above), so the allocation of the transaction price might be new to many automotive companies. Proposed model Variable consideration Variable consideration (for example, volume discounts and other sales incentives) is included in the transaction price using a probabilityweighted estimate or the most likely amount (whichever is more predictive). These amounts are recognized as revenue as the entity satisfies its related performance obligations, provided the entity is reasonably assured of being entitled to the amount allocated to that performance obligation. This is generally when the entity has experience with similar types of contracts and that experience has predictive value (that is, the experience is relevant to the contract). Discounts on future transactions (for example, volume purchase agreements) are recognized as a reduction of revenue at the time of the future transaction if the customer's future purchase is considered a separate purchasing decision (for example, there is no minimum purchase requirement in the arrangement). Revenue is measured at the fair value of the consideration received or receivable. This is normally the price specified in the contract, taking into account the amount of any trade discounts and volume rebates allowed by the entity. For contracts that provide customers with volume discounts, revenue is measured by reference to the estimated volume of sales and the Rebates on volume purchases should corresponding expected discounts. be recognized on a systematic and Revenue recognized should not exceed rational basis. Measurement of the the amount of consideration that would total rebate obligation should be based be received if the maximum discounts on the estimated number of purchases were taken if estimates of expected the customer will ultimately earn under discounts cannot be reliably made. the arrangement. If the discount cannot be reliably estimated, revenue is reduced by the maximum potential rebate. Current U.S. GAAP Current IFRS

Consideration payable to a customer Amounts paid to a customer (for example, cash rebates) are: (a) a reduction of the transaction price; (b) a payment for distinct goods or services that the entity receives from the customer; or (c) a combination of (a) and (b). If consideration paid is a reduction of the transaction price, management reduces the amount of revenue it recognizes at the later of when:
(a) The entity transfers the promised

Cash consideration given by a vendor to a customer is a reduction of revenue earned from the customer, unless the vendor receives an identifiable benefit (goods or services) from the customer and the fair value of such benefit can be reasonably estimated.

Cash consideration given by a vendor to a customer is a reduction of revenue earned from the customer, unless the vendor is purchasing goods or services from the customer.

Sales incentives offered to customers are typically recorded as a reduction of Sales incentives offered to customers revenue at the later of the date at which are typically recorded as a reduction of the related sale is recorded by the revenue at the later of the date at which vendor and the date at which the sales the related sale is recorded by the incentive is offered. vendor and the date at which the sales incentive is offered.

goods or services to the customer; and


(b) The entity incurs the obligation to

pay the consideration to the customer (even if payment is conditional on a future event).

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Proposed model Time value of money The transaction price should reflect the time value of money whenever the contract includes a significant financing component. As a practical expedient, an entity does not need to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less. Allocating the transaction price The transaction price (and any subsequent changes) is allocated to each separate performance obligation based on relative standalone selling price. The best evidence of a standalone selling price is the observable price of a good or service when sold separately. The standalone selling price should be estimated if the actual selling price is not directly observable. An estimation method is not prescribed in the proposed standard. An entity might use, for example, cost plus a reasonable margin in estimating the selling price of a good or service. An entity should maximize the use of observable inputs when estimating the standalone selling price. An entity may also allocate a discount or an amount of contingent consideration entirely to one (or more) performance obligations if certain conditions are met. Potential Impact:

Current U.S. GAAP

Current IFRS

Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. The interest component should be computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable when discounting is required.

Revenue is discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate should be used to determine the amount of revenue to be recognized as well as the separate interest income to be recorded over time.

There is a hierarchy for determining the standalone selling price of a deliverable. This hierarchy requires selling price to be based on vendorspecific objective evidence (VSOE) if available, third-party evidence (TPE) if VSOE is not available, or estimated selling price if neither VSOE nor TPE is available. An entity must make its best estimate of selling price in a manner consistent with that used to determine the price to sell the deliverable on a standalone basis. No estimation methods are prescribed; however, examples include the use of cost plus a reasonable margin.

The transaction price should be allocated to the separate elements of the arrangement based on relative fair value when elements in a single contract are accounted for separately. The price that is regularly charged when an item is sold separately is the best evidence of the items fair value. At the same time, under certain circumstances, a cost-plus-reasonablemargin approach to estimating fair value would be appropriate. The use of the residual method and, under rare circumstances, the reverse residual method might be acceptable to allocate arrangement consideration.

Variable consideration can take several forms. For example, variable consideration might be created by the introduction of incentives that reduce the transaction price, such as volume discounts. The proposed standard would affect some U.S. GAAP reporting entities, as it will require incentives to be accounted for similar to current IFRS. Volume discounts are often recorded only to the extent of the amount potentially due to the customer under current U.S. GAAP. The proposed standard requires that the discounts expected to be taken by the customer over the contract period be considered in estimating the transaction price. This might result in earlier recognition of discounts as compared to today. The entity estimates the amount of discounts using a probability-weighted or most likely outcome approach, whichever is most predictive of the discounts expected to be taken. Consideration paid to a customer that is a reduction of the transaction price (for example, cash rebates offered to end consumers by an OEM through its distribution network) will continue to be accounted for as a reduction of revenue. The promise to pay consideration might be implied based on an entity's customary business practice. Revenue might be reduced at an earlier point in time compared to current practice based on the proposal's requirement to consider customary business practice.

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Proposed model

Current U.S. GAAP

Current IFRS

Time value of money could also impact the amount of revenue recognized by OEMs as compared to today. Take an example of a vehicle warranty that the customer has the option to purchase separately, or a free maintenance program. The consideration for separately purchased warranties and free maintenance is typically received at the time of the vehicle sale to the end customer, yet the performance obligation is typically satisfied over a number of years. The transaction price allocated to the warranty or the free maintenance performance obligations should reflect the time value of money as interest under the proposed standard in such cases, resulting in less revenue recognized as compared to today. The sale price in a tooling arrangement between a supplier and an OEM is often structured either as separate payments at contractually stated amounts (typically equal to the supplier's cost of providing the tooling) or built into the sales price of the follow-on production parts. The proposed standard requires the transaction price to be allocated to the tooling and parts based on their estimated standalone selling prices (for example, using a cost plus a reasonable margin approach) when the tooling and parts contracts are combined but the performance obligations should be accounted for separately. A portion of the transaction price charged for each follow-on production part will need to be allocated to the tooling under the proposed model regardless of how the tooling arrangement is structured.

Key change from the 2010 Exposure Draft: The original exposure draft required variable consideration to be estimated using the probability-weighted estimate approach. An entity would use a most-likely amount approach in estimating the amount of variable consideration it expects to be entitled to receive under the proposed standard if that is the most predictive approach (for example, in situations where variable consideration is binary). The boards added the constraint on when revenue related to variable consideration can be recognized. Judgment will be necessary to determine when an entity is reasonably assured to be entitled to variable consideration and such amounts should be recognized. We expect automotive entities in many cases will have experience with similar types of contracts that are predictive and provide a basis for estimating and recognizing revenue related to variable consideration. As a practical expedient, an entity does not need to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less. This change from the original exposure draft reduces the potential impact the accounting for the time value of money will have on contract revenues relative to the boards' original proposal. Entities will likely still need to account for the time value of money in more instances under the proposed model as compared to existing practice (for example, certain tooling contracts, free maintenance arrangements, or certain warranty agreements).

Example 8 - Variable consideration (volume discount)


Facts: A supplier sells a component to an OEM for $100. The price for each component purchased in excess of 1,000 is $50 (that is, components 1 through 1,000 are $100; components 1,001 and on are $50). For simplicity, assume the supplier believes there is a 25% probability that the OEM will purchase 1,000 components and a 75% probability that the OEM will purchase 1,500 components. The supplier's assumptions are based on experience with this OEM with similar contracts, as well as its ongoing relationship with the OEM and insight it has regarding the OEM's planned production. The supplier has determined that the probability-weighted estimate is more predictive of the amount it expects to be entitled to receive than an estimate based on the most likely amount. How should the supplier determine the transaction price? Discussion: The supplier should consider the total volume discounts expected to be taken under the contract in determining the transaction price to be allocated to each component sold. The transaction price is $86.36 (probabilityweighted consideration of $118,750/probability-weighted number of parts of 1,375) for each component, determined using the probability weighted average of the expected outcomes.

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Probability-weighted consideration $100,000 (1,000 components x $100) x 25% $125,000 ((1,000 components x $100) + (500 components x $50)) x 75%: Total probability weighted consideration: Probability-weighted number of parts 1,000 components x 25%: 1,500 components x 75%: Total probability-weighted number of parts $ $ $ 250 1,125 1,375 $ 25,000 $ 93,750 $ 118,750

Revenue is recognized based on this estimated transaction price as it is reasonably assured of being received given that the supplier has experience with similar performance obligations and that experience is predictive. Any changes to the probability-weighted amount would be recognized in the period of change using a cumulative catch-up approach.

Example 9 - Allocating the transaction price


Facts: An entity enters into a contract to sell a vehicle and provide maintenance services for a three-year period. The transaction price, at inception, is $40,000. The car and the maintenance services are typically sold separately by the entity for $40,000 and $2,000, respectively. There is therefore a $2,000 inherent discount that the entity is offering to the customer. Discussion: The entity must first assign a standalone selling price to both the car and the maintenance services to allocate the contract consideration. As the car and maintenance services are sold separately, the transaction price of $40,000 would be allocated as follows using a relative allocation model: Car: Maintenance: $38,100 = $40,000 * ($40,000/$42,000) $1,900 = $40,000 * ($2,000 / $42,000)

Recognize revenue when performance obligations are satisfied


Revenue recognition under existing guidance used in the automotive industry is based primarily on the transfer of risks and rewards. Revenue is recognized upon the satisfaction of an entity's performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or continuously over time. The change to a control transfer model will require careful assessment of when an entity can recognize revenue. We expect revenue will be recognized similar to today for many automotive contracts related to the sale of production goods. This should, however, not be assumed; in particular for certain tooling contracts. Contracts between suppliers and OEMs for the sale of tooling (that is, where ownership of the tooling transfers from the supplier to the OEM) are common and can be organized in several different forms. One type of arrangement between suppliers and OEMs is where the supplier receives a lump-sum payment from the OEM or is reimbursed periodically as certain milestones are met in the completion of the pre-production tooling activities. Suppliers will have to assess the terms of the contract, using the indicators described below, to determine if control of the tooling transfers at a point in time or over time as the tooling is being constructed.

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Proposed model Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time. A performance obligation is satisfied over time when (a) the entity's performance creates or enhances an asset that the customer controls or (b) the entity's performance does not create an asset with alternative use to the entity and at least one of the following is met: The customer simultaneously receives and consumes the benefits as the entity performs each task. Another entity would not need to substantially reperform the tasks performed to date if it were to fulfill the remaining obligation. The entity has a right to payment for performance to date and expects to fulfill the contract. A performance obligation is satisfied and control is transferred at a point in time when the criteria above are not met. Determining when control transfers could require a significant amount of judgment. Indicators that might be considered in determining whether the customer has obtained control at a point in time include: The entity has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis.

Current U.S. GAAP

Current IFRS

Revenue for the sale of goods is Revenue for the sale of goods is generally recognized once the risks and generally recognized once the following rewards of ownership have transferred conditions are satisfied: to the customer. The risks and rewards of ownership have transferred; Revenue for arrangements in the scope of construction accounting is generally The seller does not retain recognized using the percentage-ofmanagerial involvement to the completion method when reliable extent normally associated with estimates are available. ownership nor retain effective control; The amount of revenue can be reliably measured; It is probable that the economic benefit will flow to the entity; and The costs incurred can be measured reliably. Revenue for arrangements in the scope of construction accounting is generally recognized using the percentage-ofcompletion method when reliable estimates are available.

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Proposed model Potential Impact:

Current U.S. GAAP

Current IFRS

The proposed guidance will require suppliers that enter into tooling arrangements to use judgment to determine when it is appropriate to recognize revenue. The overall effect of the proposed standard on a supplier will depend largely on the terms of the arrangements and the existing accounting practices for such arrangements. Revenue for tooling will be recognized as control of the tooling transfers, while revenue for the parts will likely be recognized as those parts are delivered. We expect that some contracts to construct tooling to the specification of the OEM might result in transfer of control over time, thereby permitting revenue to be recognized by the supplier over the period the tooling obligation is satisfied. Tooling arrangements often are priced with the intent to be margin-neutral (that is, the supplier will be reimbursed for actual cost). Such arrangements may provide the OEM with the right to evaluate whether the contract price of the tooling exceeds the supplier's actual cost. If that is the case, consideration received in excess of the amount of costs incurred by the supplier should be treated as variable consideration subject to the reasonably assured constraint described above.

Key change from the 2010 Exposure Draft: The 2010 exposure draft had limited guidance on when control transferred over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to comment letters received, which indicated that the guidance in the original exposure draft was difficult to apply in certain situations, such as contracts for pre-production activities related to long-term supply arrangements and services.

Example 10 - Recognize revenue (tooling: satisfied over time)


Facts: Assume the same facts as in Example 1 above, except: The tool must be constructed to the OEM's specifications, which may be changed at the OEM's request during the contract term; Non-refundable, interim progress payments are required to finance the construction of the tool; The OEM can cancel the contract to construct the tool at any time (with a termination penalty); any work in process is the property of the OEM; and Title does not otherwise pass until completion of the contract for the construction of the tool. Discussion: The OEM controls the work in process related to the tool, which suggests that the supplier transfers control of the tool over time because construction of the tool creates an asset that the OEM controls. The supplier will need to select the most appropriate measurement model (either an input or output method) to measure the amount of revenue to recognize over the contract term. The supplier might, for example, elect to use a labor hour input method if it determined that method to be the best measure of progress toward transferring control of the tooling to the OEM. The transaction price allocated to the tool is determined based on its relative estimated standalone selling price and will be recognized as revenue based on the number of labor hours incurred as a percentage of the estimated total labor hours to be incurred.

Example 11 - Recognize revenue (tooling: control transfers when the tool is completed)
Facts: Assume the same facts as in Example 1 above, except: The OEM can cancel the contract at any time (with a termination penalty) and any work is the property of the supplier; and Title of the tool passes upon completion of its construction. How should the supplier recognize revenue in this example?

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Discussion: The OEM does not control the work in process during the construction of the tool. Although the supplier is likely unable to sell the tooling to another customer and has no alternative use for the tooling, the criteria to satisfy a performance obligation over time would likely not be met as: (a) the OEM does not receive a benefit as the tool is constructed, (b) another entity would need to substantially reperform the work that the supplier has performed in order to fulfill the remaining obligation (presuming the other entity does not have the benefit of the work in process controlled by the supplier), and (c) the supplier does not have the right to payment for performance to date. We believe control is likely to transfer when the tool is completed.

Other considerations
Product warranties
Product warranties are commonplace in the automotive industry. Both OEMs and suppliers routinely provide product warranties to their customers. Suppliers, for example, generally provide a standard warranty to all customers that the product complies with agreed-upon specifications for a specified period. OEMs generally provide a standard warranty on vehicles for a certain number of years or a specified mileage. OEMs might also provide an extended warranty or certain services (for example, maintenance, roadside assistance) in addition to the standard warranty coverage. The proposed standard draws a distinction between product warranties that the customer has the option to purchase separately and those that cannot be purchased separately. Companies will need to exercise judgment when assessing a warranty not sold separately to determine if there is a service component inherent in the warranty that needs to be accounted for as a separate performance obligation. Proposed model Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. The warranty should be accounted for as a cost accrual if a customer does not have the option to purchase a warranty separately from the entity. An entity might provide a warranty that calls for a service to be provided to the customer (for example, maintenance) in addition to a promise that the entitys past performance was as specified in the contract. The entity should account for the service component of the warranty as a separate performance obligation in these circumstances. Potential Impact: This revised principle is similar to current accounting in many cases. There might, however, be situations where the accounting for warranties could result in revenue deferral, for example, when the entity's warranty provides a service to the customer (for example, maintenance, roadside assistance) in addition to a promise that the entitys past performance was as specified in the contract. The entity should account for the service component of the warranty as a separate performance obligation in these circumstances, with revenue relating to that service deferred and recognized as the service is provided. If the entity is unable to separate the service component of the warranty from the standard warranty element, then the entire warranty should be accounted for as a service and revenue should be deferred and recognized as the warranty service is provided. Current U.S. GAAP Entities typically account for warranties that cover latent defects in accordance with existing loss contingency guidance. An entity recognizes revenue and concurrently accrues any expected warranty cost when the product is sold. Revenue from separately priced extended warranty contracts is deferred and recognized over the expected life of the contract. Current IFRS Revenue is typically recognized at the time of sale for products that are sold with a standard warranty, and a corresponding provision is recognized for the expected warranty cost. A product sold with an extended warranty is treated as a multiple element arrangement. Revenue from the sale of the extended warranty is deferred and recognized over the period covered by the warranty. No costs are accrued at the inception of the extended warranty agreement.

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Proposed model

Current U.S. GAAP

Current IFRS

Entities that report under U.S. GAAP and offer separately priced warranties might also be affected, as the arrangement consideration will be allocated on a relative standalone selling price basis rather than at the contract price.

Key change from the 2010 Exposure Draft: The proposed guidance on accounting for product warranties is an area that has significantly changed from the original exposure draft. The boards originally proposed that all types of warranties, including those that provide assurances that the goods or services are as specified in the contract, be accounted for as a deferral of revenue. The accounting for warranties as a separate performance obligation will, under the proposal, be based primarily on whether the customer has the option to purchase the warranty separately, and whether it provides a service in addition to providing assurance that the entity's past performance was as specified in the contract, which is more similar to current accounting. We no longer expect there to be a significant change from current accounting for those warranties offered in the automotive industry, except possibly for more complex warranties that involve both a standard warranty and a service element.

Example 12 - Standard warranty (not offered separately)


Facts: A supplier sells parts with a 90-day standard warranty covering latent defects. The supplier will repair or replace defective components of the product under the standard warranty. How does the supplier account for the warranty? Discussion: The standard warranty is not a separate performance obligation because the customer does not have the option to purchase it separately and it does not provide a service in addition to the assurance that the product complies with agreed-upon specifications. The supplier should accrue, similar to current guidance, the cost of the warranty at the time revenue is recognized for the sale of the related product.

Example 13 - Standard warranty (not offered separately but includes a service component)
Facts: An OEM provides a product warranty to its customer with the purchase of a vehicle. The product warranty provides assurance that the vehicle is as specified in the contract and will operate as promised for up to 3 years or 36,000 miles, whichever comes first. The warranty also provides the customer with free oil changes and tire rotations during the warranty period. Customers do not have the option to purchase the warranty (including the services) separately from the vehicle. Discussion: In addition to assurance that the vehicle complies with the agreed-upon specifications in the contract, the warranty provides maintenance services (that is, oil changes and tire rotations). The maintenance services should be accounted for as a separate performance obligation and revenue related to that service should be recognized as the maintenance services are provided. The cost of the standard warranty element should be accrued at the time revenue is recognized for the vehicle. The entire warranty should be accounted for as a separate performance obligation if the OEM is unable to reasonably account for the service and standard assurance components of the warranty separately.

Contract costs
Entities in the automotive industry may incur costs to design and develop products and tooling or to build tooling that is not sold to the OEM (that is, the supplier retains ownership and the tooling is not a performance obligation). Suppliers might incur costs to develop tooling, for example, in anticipation of a long-term supply arrangement. A contract might exist prior to the costs to develop the tooling being incurred in some cases; in others, a contract might not be agreed until after costs have been incurred. These costs may be either expensed as incurred or capitalized and amortized to expense as the related revenue is recognized under current guidance. This current accounting treatment depends on a number of considerations, including the nature of the costs and the tooling being developed, whether the supplier has a noncancellable right to use the tooling, and whether the supplier will be reimbursed for the costs incurred. The proposed standard includes guidance on both costs to obtain and costs to fulfill a contract and may change today's practice.

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Proposed model Incremental costs of obtaining a contract should be recognized as an asset so long as the costs are expected to be recovered. As a practical expedient, such costs may be expensed as incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less. All costs relating to satisfied performance obligations and costs related to inefficiencies (that is, abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred.

Current U.S. GAAP

Current IFRS

There is a significant amount of Costs incurred in arrangements not in guidance on the accounting for contract the scope of construction accounting costs. are capitalized if they are within the scope of other asset standards (for Costs that are incurred for an example, inventory, property, plant anticipated contract generally may be and equipment, or intangible assets). deferred only if the costs can be directly associated with a specific contract and There is no specific cost guidance for if their recoverability from that pre-production costs incurred in contract is probable. certain automotive contracts. Pre-production costs incurred in longterm supply arrangements related to design and development of molds, dyes, and other tools that an automotive supplier will own are capitalized as part of property, plant and equipment. If the costs relate to new technology, such costs are expensed as incurred.

Other direct costs incurred in fulfilling a contract should be accounted for in accordance with other standards (for example, inventory, intangibles, or fixed assets) if they are within the scope Pre-production costs incurred related of that guidance. to molds, dyes, and other tools that a supplier will not own may only be Direct costs of fulfilling a contract will capitalized if they meet certain criteria. generally be expensed as incurred Those criteria include the supplier under the proposed standard (if not having a non-cancellable right to use within the scope of other standards), the molds, dyes, and tools during the unless they relate directly to a contract, supply arrangement or a legally relate to future performance, and are enforceable contractual guarantee for expected to be recovered. reimbursement. Otherwise, such costs are expensed as incurred. Capitalized costs are amortized as control of the goods or services to which the asset relates is transferred to the customer, which may include goods or services provided under specific anticipated contracts. Potential Impact: We expect costs associated with pre-production activities, such as those associated with long-term supply arrangements, might be capitalized more often under the proposed standard than under both current U.S. GAAP and current IFRS.

Key change from the 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the 2010 exposure draft. The boards revised this guidance to require recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered (unless the amortization period of the asset that the entity otherwise would have recognized is one year or less). Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained. The boards clarified that costs to fulfill a contract are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of wasted materials, labor, and other resources that were not considered in the price of the contract should be recognized as an expense when incurred.

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Example 14 - Costs to obtain a contract (sales commissions)


Facts: A salesperson earns a 5% commission on a contract that was signed in January. The products purchased under the contract will be delivered throughout the next year. The contract is not expected to be renewed in the following year. How should the entity account for the commission paid to its employee? Discussion: The commission payment may be recognized as an asset and amortized as control of the products purchased under the contract is transferred in the following year. The commission payment may also be expensed as incurred in this case because of the practical expedient to allow such costs to be expensed if the amortization period of the asset (that is, the commission paid to obtain the contract) is one year or less.

Financing arrangements
Many OEMs have finance arms that serve as a potential finance source for customers that lease or buy vehicles from dealers. When vehicles sold to dealers are financed through the OEM's financing division, the OEM must meet certain conditions under current U.S. GAAP to recognize revenue at the time of vehicle delivery to the dealer. These specific conditions are not included in IFRS; rather, revenue is generally recognized from sales to dealers or distributors when the risks and rewards of ownership have passed. The proposed standard does not contain the same conditions that exist under current guidance. Proposed model The proposed standard requires revenue to be recognized when control transfers to the customer (see above). Current U.S. GAAP When an OEM sells a vehicle to a dealer who in turn leases it to an end customer, and the end customer finances the lease through the OEM (or its finance affiliate), the OEM may recognize revenue upon sale to the dealer if certain conditions are met, including: The dealer is an independent entity; The OEM has delivered the product to the dealer and the risks and rewards of ownership have passed to the dealer; The finance affiliate of the OEM has no legal obligation to provide a lease arrangement to a potential customer of the dealer; and The customer has other financing alternatives available and controls the selection of the financing alternative. Potential Impact: OEMs generally meet the criteria in U.S. GAAP to recognize revenue at the time of sale to the dealer. We do not expect a significant change in the timing of revenue recognition in such cases as a result of the elimination of the criteria in current U.S. GAAP. This is because it is likely that control has transferred if the transaction meets the specific criteria under existing guidance. The proposal may result in earlier revenue recognition for OEMs that did not meet the criteria under current U.S. GAAP. We also do not expect a significant change in the timing of revenue recognition under IFRS. Transfer of control generally occurs when a vehicle is sold from the OEM to the dealer. Current IFRS There are no specific criteria for when an OEM sells a vehicle to a dealer who in turn leases it to an end customer, and the end customer finances the lease through the OEM. Revenue from sales to distributors, dealers, or others for resale is generally recognized when the risks and rewards of ownership have passed. The sale is treated as a consignment sale when the dealer is acting in substance as an agent.

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Example 15 - Lease financing arrangements


Facts: An OEM sells a vehicle to a dealer. The dealer has legal title and an obligation to pay the OEM upon receipt of the vehicle. The dealer intends to sell or lease the vehicle to a third party. The third party may finance the purchase or lease of the vehicle from the dealer through a finance affiliate of the OEM or through an unrelated third party. When should revenue be recognized for the sale of the vehicle to the dealer? Discussion: The dealer has physical possession, legal title, and an obligation to pay the OEM upon receipt of the vehicle. Control transfers and the OEM should recognize revenue when the dealer receives the vehicle. The fact that the OEM might provide financing to the end consumer that ultimately purchases or leases the vehicle from the dealer does not impact the assessment of whether control has transferred.

Repurchase options and residual value guarantees


OEMs sell vehicles to customers and often include various repurchase or reimbursement options as part of the contract, as is common in arrangements with rental car companies. These options generally provide some form of a guaranteed residual value to the customer when the customer sells the vehicle. Two common options are when OEMs either agree to (a) reacquire the vehicle at a guaranteed price or (b) reimburse customers for any deficiency between the sales proceeds received for the vehicle and the guaranteed minimum resale value. There is specific U.S. GAAP that requires these contracts to be treated as lease transactions under today's accounting. IFRS does not contain specific guidance on how to account for such arrangements. Proposed model The proposed standard differentiates the accounting based on whether the OEM has an obligation to reacquire the vehicle or is required to reimburse the customer for any deficiency between the sales proceeds and a minimum resale value. An OEM would account for an agreement that provides the customer with the unconditional right to require the OEM to repurchase the vehicle (that is, a put option) as a lease if, at contract inception, the customer has a significant economic incentive to exercise that right. The OEM would account for the agreement as a sale with a right of return if the customer does not have a significant economic incentive to require the OEM to repurchase the vehicle. The proposed standard applies to agreements to reimburse customers for any deficiency between the sales proceeds received for the vehicle and a guaranteed minimum resale value. We expect that such agreements might result in recognition of revenue when control of the vehicle is transferred, with the estimate of the expected reimbursement to the customer accounted for as variable consideration payable to the customer and a reduction of revenue (see above discussion).
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Current U.S. GAAP An entity should account for a transaction in which it has agreed to (a) reacquire the product at a guaranteed price or (b) reimburse the customer for any deficiency between the sales proceeds received for the product and the guaranteed minimum resale value as a lease.

Current IFRS There is no specific guidance on how to account for an arrangement in which the entity has agreed to (a) reacquire the product at a guaranteed price or (b) reimburse the customer for any deficiency between the sales proceeds received for the product and the guaranteed minimum resale value. An entity should evaluate the substance of the transaction to determine whether the arrangement is a lease or sale.

Dataline 17

Proposed model Potential Impact:

Current U.S. GAAP

Current IFRS

Contracts containing repurchase options are common for certain OEMs. We believe these contracts will generally be accounted for under the proposed standard, but will be accounted for as a lease when the customer has the unconditional right to require the OEM to repurchase the vehicle and the customer has a significant economic incentive to exercise that right. Agreements to reimburse customers for any deficiency between the sales proceeds received for the vehicle and the guaranteed minimum resale value will be accounted for under the proposed standard as a reduction of the transaction price, not as a lease. The boards have also proposed significant changes to the accounting for leases, which might result in a different pattern of recognition as compared to today's lease accounting.

Key change from the 2010 Exposure Draft: The 2010 exposure draft required an entity to account for all transactions that provide the customer with the right to require the entity to repurchase the product in the future as a sale of a product with a right of return. The boards subsequently concluded that when the customer has a significant economic incentive to require the entity to repurchase the asset, the substance of the transaction is to provide the right to use the asset and should be accounted for as a lease.

Right of return
Return rights in the automotive industry are common and come in a variety of forms. These arrangements will require careful consideration as to the appropriate accounting under the proposed model. Proposed model The sale of goods with a right of return would be recorded as revenue on the date of sale, and the amount of estimated returns should be accounted for similar to today's failed sale model. Revenue should not be recognized for goods expected to be returned, and a liability should be recognized for the expected amount of refunds to customers. The refund liability should be updated for changes in expected refunds. An asset and corresponding adjustment to cost of sales should be recognized for the right to recover goods from customers on settling the refund liability, with the asset initially measured at the original cost of the goods (that is, the former carrying amount in inventory). The asset should be assessed for impairment if indicators of impairment exist. If an entity is not reasonably assured of the quantity of products that will be returned, revenue will not be recognized until the entity is reasonably assured of the quantity of
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Current U.S. GAAP Revenue is recognized at the time of sale if the amount of 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.

Current IFRS Revenue is typically recognized net of a provision for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an established historical record and other relevant evidence.

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Proposed model products that will be returned (which may be when the right of return lapses). Potential Impact:

Current U.S. GAAP

Current IFRS

The affect of product returns under the proposed standard will be largely unchanged from current guidance under U.S. GAAP and IFRS, with the primary change being that the balance sheet will be grossed up to include the refund obligation and the asset for the right to goods to be returned. Companies will use a probability-weighted approach or most likely outcome, whichever is most predictive, to determine the likelihood of a sales return under the proposed standard, which may result in a difference versus current accounting.

Principal versus agent


Entities will need to determine whether they are the principal or the agent when providing goods or services to a customer. For example, the supplier will need to assess whether its performance obligation is to provide the tooling itself (that is, the supplier is a principal and should present revenue from the tooling arrangement on a gross basis), or to arrange for another party to provide the tooling (that is, the supplier is an agent and should present revenue from the tooling arrangement on a net basis) when a supplier outsources the construction of tooling. Proposed model An entity is the principal when it obtains control of the goods or services of another party before it transfers those goods or services to the customer. (Refer to discussion of control transfer in the "recognize revenue when performance obligations are satisfied" section above.) Indicators that the entity is an agent and should recognize revenue net of amounts paid to others for providing their goods or services to the customer include: The other party is primarily responsible for fulfillment of the contract. The entity does not have inventory risk before or after the customer order, during shipping, or on return. The entity does not have latitude in establishing prices for the other party's goods or services; thus, the benefits it can receive from the goods or services are constrained. The entity's consideration is in the form of a commission. The entity does not have customer credit risk for the amount receivable in exchange for the other party's goods or services. Current U.S. GAAP An entity should assess whether it is acting as a principal or an agent in an arrangement. Revenue is the amount of the commission (that is, net presentation) in an agency relationship. Specific indicators are provided for entities to consider when assessing whether the entity is the principal or the agent in an arrangement. Current IFRS An entity should assess whether it is acting as a principal or an agent in an arrangement. Revenue is the amount of the commission (that is, net presentation) in an agency relationship. Specific indicators are provided for entities to consider when assessing whether the entity is the principal or the agent in an arrangement.

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Proposed model Potential Impact:

Current U.S. GAAP

Current IFRS

The proposed guidance for determining whether revenue should be presented gross or net is similar to today's guidance and will likely not result in a significant change. This should not, however, be assumed. Entities will have to assess their current accounting for items such as tooling and service warranty contracts, and their allocation of consideration using the principles in the proposed standard to determine that their accounting is appropriate.

Onerous performance obligations


The accounting for onerous performance obligations could represent a significant change for automotive companies based on the holistic application of the proposed standard. For example, suppliers might enter into a contract to construct and deliver tooling to an OEM at a loss as part of a contract that includes a supply agreement for the production of the parts the tool was created for (presumably at a price that would result in the overall contract being profitable). A loss may need to be recorded for the tooling depending on the allocation of consideration determined based on the relative standalone selling prices. Proposed model An entity shall recognize a liability and a corresponding expense if a performance obligation that will be satisfied over a period of time greater than one year is onerous. A performance obligation is onerous if the lower of (a) the costs that relate directly to satisfying the performance obligation by transferring the promised goods or services and (b) the amount the entity would pay to exit the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. Potential Impact: The proposal to account for onerous contracts at the performance obligation level will likely result in more liabilities being recognized as compared to current accounting. Management may be reluctant to enter into contracts that include lossmaking performance obligations with the expectation of overall profitability in light of this proposed guidance. Current U.S. GAAP The recognition of onerous provisions for executory contracts generally is not permitted outside of certain specific guidance (for example, construction contract guidance). Current IFRS A loss should be recorded on a contract that is outside of the scope of accounting for construction contracts when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. A loss shall be recognized on a contract within the scope of accounting for construction contracts when it is probable that total contract costs will exceed total contract revenue.

Key change from the 2010 Exposure Draft: Onerous performance obligations were to be evaluated at the performance obligation level for all performance obligations under the 2010 exposure draft. The boards changed this to apply only to performance obligations satisfied over a period of time greater than one year in response to comments about the unintended consequences of the proposed requirement. Performance obligations that are not satisfied over a period of time greater than one year would not be subject to the guidance on onerous performance obligations under the proposed standard.

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Authored by:
Richard Hanna Global Sector & Assurance Leader Phone: 1-313-394-3450 Email: richard.hanna@us.pwc.com Lawrence Dodyk Partner Phone: 1-973-236-7213 Email: lawrence.dodyk@us.pwc.com Michael Sobolewski Senior Manager Phone: 1-313-394-3299 Email: michael.sobolewski@us.pwc.com Jason Aeschliman Senior Manager Phone: 1-973-236-4983 Email: jason.a.aeschliman@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

US GAAP Convergence & IFRS Revenue recognition: Engineering and construction industry supplement

Dataline A look at current financial reporting issues


No. 2011-35 (supplement) November 22, 2011 Whats inside: Overview .......................... 1 Defining the contract ..... 2 Determining the transaction price.......... 4 Accounting for multiple performance obligations .....................7 Allocating the transaction price.......... 8 Recognize revenue ........ 10 Other considerations ..... 14 Final thoughts ................18

Revenue from contracts with customers The proposed revenue standard is re-exposed

Engineering and construction industry supplement


Overview
Entities in the engineering and construction (E&C) industry applying U.S. GAAP or IFRS 1 have primarily been following industry guidance for construction contracts to account for revenue. These standards were developed to address particular aspects of long-term construction accounting and provide guidance on a wide range of industry specific considerations including: Defining the contract, such as when to combine or segment contracts, and when and how to account for change orders and other modifications Defining the contract price, including variable consideration, customer furnished materials, and claims Recognition methods, such as the percentage-of-completion method (and in the case of U.S. GAAP, the completed contract method) and input/output methods to measure performance Accounting for contract costs, such as pre-contract costs and costs to fulfil a contract Accounting for loss making contracts

This guidance is included in ASC Topic 605-35, Construction-Type and Production-Type Contracts (U.S. GAAP), and International Accounting Standards 11, Construction Contracts (IFRS).

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Dataline

Once the new revenue recognition standard becomes effective, the construction contract guidance and substantially all existing revenue recognition guidance under U.S. GAAP and IFRS will be replaced. This includes the percentage-ofcompletion method and the related construction cost accounting guidance as a standalone model. This E&C industry supplement discusses the areas in which the proposed standard is expected to have the greatest impact. The examples and the related assessments contained herein are based on a current interpretation of the exposure draft, Revenue from Contacts with Customers , issued on November 14, 2011. Any conclusions set forth below are subject to further interpretation and assessment based on the final standard. We have also provided a high-level summary of key changes from the original exposure draft issued on June 24, 2010 (the "2010 Exposure Draft"). References to the proposed model or proposed standard throughout this document refer to the exposure draft issued in November 2011, unless otherwise indicated. For a more comprehensive description of the proposed standard, refer to PwC Dataline 201135 (www.cfodirect.pwc.com) or visit www.fasb.org or www.ifrs.org.

Defining the contract


Current guidance covers: When two or more contracts should be combined and accounted for together When one contract should be segmented and accounted for separately as two or more contracts When a contract modification should be recognized These situations and, in particular, contract modifications such as change orders, are commonplace in the E&C industry. The proposed standard applies only to contracts with customers when such contracts: Have commercial substance Have been approved by the parties to the contract and such parties are committed to satisfying their respective obligations Have enforceable rights that can be identified regarding the goods or services to be transferred Have terms and manners of payment that can be identified Current practice is not expected to significantly change in the assessment of whether contracts should be combined. The proposed standard does not contain guidance on segmenting contracts; however, construction companies that currently segment contracts under current guidance might not be significantly affected because of the requirement in the proposed standard to account for separate performance obligations (refer to "Accounting for multiple performance obligations" below). Construction companies currently exercise significant judgment to determine when to include change orders and other contract modifications in contract revenue and therefore, there is diversity in practice. We expect that the use of judgment will continue to be needed and do not expect current practice (or existing diversity) in this area to be significantly affected by the proposed standard, including the accounting for unpriced change orders. Proposed model Combining contracts Two or more contracts (including contracts with parties related to the customer) are combined and accounted for as one contract if the contracts are entered into at or near the same time and one or more of the following conditions are met: Combining and segmenting contracts is Combining and segmenting contracts is permitted provided certain criteria are required when certain criteria are met. met, but it is not required so long as the underlying economics of the transaction are fairly reflected. Current U.S. GAAP Current IFRS

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Dataline

Proposed model The contracts are negotiated with a single commercial objective The amount of consideration in one contract depends on the other contract The goods or services promised are a single performance obligation (refer to "Accounting for multiple performance obligations" below) Contract modifications (for example, change orders) An entity shall account for a modification when the entity has an expectation that the price of the modification will be approved if the parties to a contract have approved a change in the scope of a contract but have not yet determined the corresponding change in price (for example, unpriced change orders). A contract modification is accounted for as a separate contract if: the modification promises distinct goods or services that result in a separate performance obligation; and the entity has a right to consideration that reflects the standalone selling price of the promised goods or services underlying that performance obligation. A modification that is not a separate contract is evaluated and accounted for either as: A termination of the original contract and the creation of a new contract if the goods or services are distinct from those transferred before the modification A cumulative adjustment to contract revenue if the remaining goods and services are not distinct and part of a single performance obligation that is partially satisfied

Current U.S. GAAP

Current IFRS

A change order is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. U.S. GAAP also includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be performed is defined, but the price is not).

A change order (known as a variation) is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders.

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Dataline

Proposed model A prospective adjustment to contract revenue when the remaining goods or services are a combination of distinct and nondistinct

Current U.S. GAAP

Current IFRS

Example 1 - Unpriced change orders


Facts: A contractor has a single performance obligation to build an office building. The contractor has a history of executing unpriced change orders; that is, those change orders where price is not defined until after scope changes are agreed upon. It is not uncommon for the contractor to commence work once the parties agree to the scope of the change, but before the price is agreed upon. When would these unpriced change orders be included in contract revenue? Discussion: The contractor might be able to determine that it expects the price of the scope change to be approved based on its historical experience. If so, the contractor would account for the unpriced change order and estimate the transaction price based on a probability-weighted or most likely amount approach (whichever is most predictive). The contractor would need to then determine whether the unpriced change order should be accounted for as a separate contract. This will often not be the case based on the following: Change orders often wont result in a distinct performance obligation because the underlying good or service is highly interrelated with the original good or service and part of the contractor's service of integrating goods into a combined item for the customer. Change orders are typically based on the contractor's goal of obtaining one commercial objective on the overall contract. The pricing of a change order may, as a result, not represent the standalone selling price of the additional good or service. The contractor in this case would update the transaction price and measure of progress towards completion of the contract because the remaining goods or services, including the change order, are part of a single performance obligation that is partially satisfied.

Determining the transaction price


The transaction price (or contract revenue as it is called today in the E&C industry) is the consideration the contractor expects to be entitled to in exchange for satisfying its performance obligations. This determination is simple when the contract price is fixed. It is more complex when the contract price is not fixed. Common considerations in this area for the E&C industry include the accounting for awards/incentive payments, customer-furnished materials, claims, liquidated damages, and the time value of money. Revenue related to awards or incentive payments might be recognized earlier under the proposed standard. We do not expect a significant change in practice as it relates to customer furnished materials, claims, liquidated damages, or the time value of money, except as it relates to the impact of the time value of money on retainage receivables. Proposed model Awards/incentive payments Awards/incentive payments are included in contract revenue using a probability-weighted or most likely amount approach (whichever is more predictive). These amounts are Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. Current U.S. GAAP Current IFRS

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Proposed model recognized as revenue as the entity satisfies its related performance obligations, provided the entity is reasonably assured of being entitled to the amount allocated to that performance obligation. This is generally when the contractor has experience with similar types of contracts and that experience has predictive value (i.e., the experience is relevant to the contract). Customer furnished materials The value of goods or services contributed by a customer (for example, materials, equipment, or labor) to facilitate the fulfillment of the contract is included in contract revenue if the entity controls these goods or services. Any non-cash consideration is measured at fair value unless fair value cannot be reasonably estimated, in which case it is measured by reference to the selling price of the goods or services transferred. Claims Claims are included in contract revenue using a probability-weighted or most likely amount approach (whichever is more predictive). These amounts are recognized as the entity satisfies its related performance obligations, provided the entity is reasonably assured of being entitled to such payments (see above). Time value of money Contract revenue should reflect the time value of money whenever the contract includes a significant financing component. An entity is not required to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less, as a practical expedient.

Current U.S. GAAP

Current IFRS

The value of customer furnished materials is included in contract revenue when the contractor has the associated risk for these materials.

There is no explicit guidance on the accounting for non-cash consideration in the construction contracts standard. Management would follow general principles on nonmonetary exchanges, which generally require companies to use the fair value of goods or services received in measuring the amount to be included in contract revenue.

A claim is recorded as contract revenue when it is probable and can be estimated reliably (determined based on specific criteria), but only to the extent of contract costs incurred. Profits on claims are not recorded until they are realized.

A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured.

Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. The interest component is computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable when discounting is required.

Revenue is discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate is used to determine the amount of revenue to be recognized as well as the separate interest income to be recorded over time.

Key change from the 2010 Exposure Draft: The original exposure draft required variable consideration to be estimated using the probability-weighted estimate approach. Entities may now use a most-likely amount approach if it is the most predictive (for example, in situations where variable consideration is binary). This might provide results more similar to today's accounting.

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The boards added a constraint on when revenue related to variable consideration (for example, bonus, claims, and awards) can be recognized. Judgment will be necessary to determine when an entity is reasonably assured of being entitled to receive variable consideration based on the conditions described above and thus, when the related revenue should be recognized. As a practical expedient, a contractor does not need to consider the time value of money if the period between payment and the transfer of the promised goods or services is one year or less. This change from the original exposure draft reduces the potential impact of the accounting for the time value of money on contract revenues. Entities might still need to account for the time value of money in more instances under the proposed model as compared to existing practice (for example, retainage receivables).

Example 2 - Variable consideration


Facts: A contractor enters into a contract for the expansion of an existing two-lane highway to a three-lane highway. The contract price is $65 million plus a $5 million award fee if the expansion is completed before the holiday travel season. The contract is expected to take one year to complete. The contractor has a long history of performing this type of highway work. The award fee is binary; that is, if the job is finished before the holiday travel season, the contractor receives the full award fee. The contractor does not receive any award fee if the highway is not finished before the holiday season. The contractor believes, based on significant past experience, that it is 95 percent likely that the contract will be completed in advance of the holiday travel season. How should the contractor account for the award fee? Discussion: The contractor is likely to conclude, given the binary award fee, that it is appropriate to use the most likely amount approach in determining the amount of variable consideration to include in the estimate of the transaction price. The contract's transaction price is therefore $70 million: the fixed contract price of $65 million plus the $5 million award fee (most-likely amount). This estimate is regularly revised and adjusted, as appropriate, using a cumulative catch-up approach, which is consistent with current practice. The contractor will then determine whether it is reasonably assured of being entitled to the award fee (and therefore, it is eligible to recognize this amount as revenue when the performance obligation is satisfied). The contractor would likely conclude it is reasonably assured of being entitled to the award fee based on its history with similar contracts that provide predictive experience. Factors to consider include, but are not limited to: The contractor has a long history of performing this type of work It is largely within the contractor's control to complete the work before the holiday travel season The uncertainty will be resolved within a relatively short period of time This should not result in a significant change from todays accounting for variable consideration in many E&C contracts.

Example 3 - Claims
Facts: Assume the same fact pattern as Example 2, except that due to reasons outside of the contractor's control (for example, owner-caused delays), the cost of the contract far exceeds original estimates (but a profit is still expected). The contractor submits a claim against the owner to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with owners, albeit sometimes at a discount from the amount sought. How should the contractor account for the claim?

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Discussion: Claims are highly susceptible to external factors (such as the judgment of or negotiations with third parties), and the possible outcomes are highly variable. The contractor may have experience in successfully negotiating claims, but it might be challenging to assert that such experience has predictive value in this fact pattern (because of the highly uncertain variables). The contractor might therefore conclude that it is not reasonably assured of being entitled to receive such a claim in the early stages. The amount of the claim is included in the transaction price when initiated using either a probability-weighted approach or most likely outcome amount (whichever is more predictive), but it cannot be recognized until the contractor is reasonably assured of being entitled to receive the claim. This is likely to occur at a date closer to the date the claim is expected to be resolved.

Accounting for multiple performance obligations


Performance obligations are defined as promises to deliver goods or perform services. Contractors often account for each contract at the contract level today; that is, contractors account for the macro-promise in the contract (for example, to build a road or build a refinery). Current guidance permits this approach, although a contractor effectively promises to provide a number of different goods or perform a number of different services in delivering such macro-promises. Determining when to separately account for these performance obligations under the proposed model is a key determination and will require a significant amount of judgment. It is possible to account for the contract at the contract level (for example, the macro-promise to build a road) under the proposed model when the criteria for combining a bundle of goods or services into one performance obligation. We expect, however, that contractors might have to separately account for more obligations within each contract compared to current guidance. Significant judgment will be needed, for example, in the case of engineering, procurement, and construction (EPC) contracts. Proposed model Performance obligations separation An entity should separately account for performance obligations only if the pattern of transfer is different and they are distinct. A good or service is distinct if either of the following criteria are met: The entity regularly sells the good or service separately The customer can use the good or service on its own or together with other readily available resources An entity should account for two or more performance obligations as a single performance obligation when the following criteria are met: The goods or services are highly interrelated The entity provides a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted The basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. That presumption may be overcome only if a contract or a series of contracts meets the conditions described above for combining or segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract under the construction contract guidance. The basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. That presumption is overcome when a contract or a series of contracts meets the conditions described for combining or segmenting contracts. There is no further guidance around separately accounting for more than one deliverable in a construction contract. Current U.S. GAAP Current IFRS

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Proposed model The bundle of goods or services is significantly modified or customized to fulfil the contract Goods and services that are not distinct and therefore, not separate performance obligations, should be combined with other performance obligations until the entity identifies a bundle of goods or services that is distinct.

Current U.S. GAAP

Current IFRS

Key change from the 2010 Exposure Draft: The boards have clarified the principle for when to separately account for performance obligations. They have now provided guidance for situations when it may be necessary to account for a promised bundle of goods or services as a single performance obligation in an effort to better reflect the economics of certain long-term contracts. We believe contractors might have to separately account for more obligations within each contract compared to current guidance notwithstanding this additional guidance.

Example 4 - Construction management contract


Facts: A contractor enters into a construction contract with an owner to provide construction management services, overseeing the construction of a new airport runway. How many performance obligations is the contractor required to separately account for? Discussion: The contractor is only providing the construction management service to supervise and coordinate the construction activity on the project and might only have one performance obligation in this example.

Allocating the transaction price


The transaction price, once determined, is allocated to the performance obligations in a contract that require separate accounting. We expect that contractors might have to separately account for more performance obligations than today if the risks of providing two or more goods or services are not largely inseparable (as described above), so the allocation of the transaction price (i.e., contract revenue) will be new to many E&C companies. Of particular interest will be the allocation of variable consideration (for example, award or incentive payments) associated with only one separate performance obligation, rather than the contract as a whole. The boards have proposed that, when certain conditions are met, an entity can allocate the transaction price entirely to one (or more) performance obligations. This would be relevant, for example, for contracts that have incentive payments wholly tied to only one performance obligation (for example, a bonus award associated with only the build component of a design/build contract). Proposed model Allocating the transaction price The transaction price (and any subsequent changes in estimate) is allocated to each separate performance obligation based on relative standalone selling price. The best evidence of a standalone selling price is the Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract, given the presumption that the contract is the Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract, given the presumption that the contract is the Current U.S. GAAP Current IFRS

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Proposed model observable price of a good or service when sold separately. The standalone selling price should be estimated if the actual selling price is not directly observable. An estimation method is not prescribed in the proposed guidance. For example, a contractor might use cost plus a reasonable margin in estimating the selling price of a good or service. An entity should maximize the use of observable inputs when estimating the standalone selling price. Entities may use a residual technique to estimate the standalone selling price (i.e., total transaction price less the standalone selling prices, actual or estimated, of other goods or services in the contract) if the standalone selling price of a good or service is highly variable or uncertain. An entity may also allocate a discount or an amount of contingent consideration entirely to one (or more) performance obligations if certain conditions are met.

Current U.S. GAAP profit center for determining revenue recognition.

Current IFRS profit center for determining revenue recognition.

Example 5 - Allocating contract revenue to more than one performance obligation


Facts: A contractor enters into a contract to build both a road and a bridge (assume for this example that there are only two performance obligations: to build the road and to build the bridge). The contractor determines at inception that the contract price is $150 million, which includes a $140 million fixed price and an estimated $10 million of award fees. The amount of the award fee is variable depending on how early the contractor finishes the entire project. The contractor will receive a base award fee if it finishes the entire project 30 days ahead of schedule. The award fee is increased (decreased) by 10% for each day before (after) the 30 days it finishes the project. The contractor has experience with similar contracts and has determined that it is reasonably assured of being entitled to an award fee of $10 million using a probabilityweighted estimate approach. How should the contractor allocate the contract price to the two separate performance obligations? Discussion: A contractor must first assign a standalone selling price to both the road and the bridge in order to allocate the contract price (including both the fixed and variable amounts). The contractor typically constructs both roads and bridges of a similar type and nature to those required by the contract on a stand-alone basis. The stand-alone selling price to build this road, based on prior experience, is $140 million. The stand-alone selling price to build this bridge, based on prior experience, is $30 million. There is an inherent discount of $20 million built into the bundled contract. The $150 million transaction price is allocated as follows using a relative allocation model: Road: Bridge: $124m ($150m * ($140m / $170m)) $ 26m ($150m * ($ 30m / $170m))

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Example 6 - Allocating contract revenue to more than one performance obligation - changes in the transaction price
Facts: Assume the same fact pattern as Example 5 above, except that the amount of variable consideration changes from an expected $10 million to an expected $12 million after contract inception. The amount of the award fee relates to the contractor's ability to finish the contract as a whole ahead of schedule and not specifically to the completion of either the road or bridge ahead of schedule. How should the contractor allocate the change in the estimated contract price? Discussion: The basis for allocating the transaction price to performance obligations (i.e., the percentage used to allocate based on relative standalone selling prices) is not changed after contract inception. The additional $2 million of contract price would be allocated to the road and bridge using the initially developed allocation percentages as follows: Road: Bridge: $1.6m ($2m * ($140m / $170m)) $0.4m ($2m * ($ 30m / $170m))

Such changes are recognized using a cumulative catch-up approach. For example, if the road was 90% complete and work on the bridge had not yet commenced at the time of the change in estimate, the contractor would recognize revenue of $1.44m ($1.6m x 90%) for the portion of the performance obligation already satisfied for the road. The contractor would recognize additional revenue of $0.56m as the remaining performance obligations related to the road ($0.16m = $1.6m x 10%) and bridge ($0.4m = $0.4m x 100%) are satisfied.

Recognize revenue
Revenue recognition under existing guidance is based on the activities of the contractor; that is, provided reasonable estimates are available, revenue can be recognized as the contractor performs (known as the percentage-of-completion method). The boards have proposed that revenue is recognized upon the satisfaction of a contractor's performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or over time. The change to a control transfer model will require careful assessment of when a contractor can recognize revenue. We expect that many construction-type contracts will transfer control of a good or service over time and therefore, might result in a similar pattern of revenue recognition compared to todays guidance . This should not, however, be assumed. Contractors will not be able to default to the method used today and a careful assessment of when control transfers will need to be performed. A cost-to-cost input method may be used today, for example, to measure revenue under an activities-based recognition model. The measure of progress toward satisfaction of a performance obligation under the proposed model should depict the transfer of goods or services to the customer. A cost-to-cost input method might not be the most appropriate measure of the extent to which control has transferred when a performance obligation is satisfied over time under the proposed model. Proposed model Transfer of control Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps most important for the E&C industry, over time. A performance obligation is satisfied over time when at least one of the following criteria is met: Revenue is recognized using the percentage-of-completion method when reliable estimates are available. The percentage-of-completion method based on a zero-profit margin is used when reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall Revenue is recognized using the percentage-of-completion method when reliable estimates are available. The percentage-of-completion method based on a zero-profit margin is used when reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (for example, when the scope of the contract is ill-defined, but the contractor is protected from an overall Current U.S. GAAP Current IFRS

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Proposed model

Current U.S. GAAP

Current IFRS loss) until more precise estimates can be made. Contract costs that are not probable of being recovered are recognized as an expense immediately. The completedcontract method is prohibited.

The entity's performance creates or loss) until more precise estimates can be made. enhances an asset that the customer controls; or The completed-contract method is The entity's performance does not required when reliable estimates create an asset with alternative use cannot be made. to the entity and at least one of the following:
-

The customer simultaneously receives and consumes the benefits as the entity performs, Another entity would not need to substantially reperform the work performed to date if that other entity were required to fulfil the remaining obligation to the customer, or The entity has a right to payment for performance completed to date.

A performance obligation is satisfied at a point in time if it does not meet the criteria above. Determining when control transfers will require a significant amount of judgment. Indicators that might be considered in determining whether the customer has obtained control of an asset at a point in time include: The entity has a present right to payment The customer has legal title The customer has physical possession The customer has the significant risks and rewards of ownership The customer has accepted the asset This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a stand-alone basis.

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Proposed model Measuring performance obligations satisfied over time A contractor should measure progress towards satisfaction of a performance obligation that is satisfied over time using the method that best depicts the transfer of goods or services to the customer. Methods for recognizing revenue when control transfers over time include: Output methods that recognize revenue on the basis of direct measurement of the value to the customer of the entity's performance to date (for example, surveys of goods or services transferred to date, appraisals of results achieved). Input methods that recognize revenue on the basis of the entity's efforts or inputs to the satisfaction of a performance obligation (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities). The method selected should be applied consistently to similar contracts with customers. Once the metric is calculated to measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognized. The effects of any inputs that do not represent the transfer of goods or services to the customer, such as abnormal amounts of wasted materials, should be excluded from the measurement of progress. It may be appropriate to measure progress by recognizing revenue equal to the costs of the transferred goods if goods are transferred at a significantly different time from the related service (such as materials the customer controls before the entity installs the materials). Estimates to measure the extent to which control has transferred (for example, estimated costs to complete

Current U.S. GAAP

Current IFRS

A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. There are two different approaches for determining revenue, cost of revenue, and gross profit once a "percentage complete" is derived: the Revenue method and the Gross Profit method.

A contractor can use either an input method (for example, cost-to-cost, labor hours, labor cost, machine hours, or material quantities), an output method (for example, physical progress, units produced, units delivered, or contract milestones), or the passage of time to measure progress towards completion. IFRS requires the use of the Revenue method to determine revenue, cost of revenue, and gross profit once a "percentage complete" is derived. The Gross Profit method is not permitted.

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Proposed model when using a cost-to-cost calculation) should be regularly evaluated and adjusted using a cumulative catch-up method.

Current U.S. GAAP

Current IFRS

Key change from the 2010 Exposure Draft: The 2010 exposure draft had limited guidance on determining when control transfers over time. The boards added the criteria above to determine when a performance obligation is satisfied over time in response to feedback that the original guidance was difficult to apply in certain situations, such as service arrangements.

Example 7 - Recognizing revenue


Facts: A contractor enters into a construction contract with an owner to build an oil refinery. The contract has the following characteristics: The oil refinery is highly customized to the owner's specifications and changes to these specifications by the owner are expected over the contract term. The oil refinery does not have an alternative use to the contractor. Non-refundable, interim progress payments are required as a mechanism to finance the contract. The owner can cancel the contract at any time (with a termination penalty); any work in process is the property of the owner. As a result, another entity would not need to reperform the tasks performed to date. Physical possession and title do not pass until completion of the contract. The contractor determined that the contract is a single performance obligation to build the refinery. How should the contractor recognize revenue? Discussion: The preponderance of evidence suggests that the contractor's performance creates an asset that the customer controls and control is being transferred over time. The contractor will have to select either an input or output method in this case to measure the progress towards satisfying the performance obligation.

Example 8 - Recognizing revenue - use of cost-to-cost


Facts: Assume the same fact pattern as Example 7 above. Additional contract characteristics are: Contract duration is three years Total estimated contract revenue is $300 million Total estimated contract cost is $200 million Year one cost is $120 million (including $20 million related to contractor caused inefficiencies) The contractor has concluded that cost-to-cost is a reasonable method for measuring the progress toward satisfying its performance obligation. How much revenue and cost should the contractor recognize during the first year?

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Discussion: The contractor should exclude any costs that do not depict the transfer of goods or services in determining the amount of revenue to be recognized under a cost-to-cost model. The costs associated with contractor caused inefficiencies would be excluded in this situation. The amounts of contract revenue and cost recognized at the end of year one are: Revenue: Contract cost (excluding inefficiencies): Gross contract margin: Contract inefficiencies: Adjusted contract margin: $150m ($300m * ($100m / $200m)) $100m $ 50m $ 20m $ 30m

Example 9 - Recognizing revenue - use of cost-to-cost with changes in estimates


Facts: Assume the same fact pattern as Examples 7 and 8 above, except that total estimated cost to complete the contract increases at the end of the second year to $250 million due to an increase in the cost of materials. Actual cumulative cost incurred as of the end of the second year (excluding year-one inefficiencies) is $200 million. How much revenue and cost should the contractor recognize during the second year? Discussion: The amount of contract revenue and cost recognized during the second year: Cumulative revenue: Revenue recognized year one: Revenue recognized year two: Cumulative costs (excluding inefficiencies): Costs recognized year one (excluding inefficiencies): Costs recognized year two: (excluding inefficiencies): Gross contract margin year two: Gross contract margin to-date (excluding inefficiencies): Adjusted contract margin to-date: $240m ($300m * ($200m / $250m) $150m $ 90m $200m $100m $100m $ (10m) ($90m - $100m) $ 40m ($240m - $200m) $ 20m ($240m - $200m - $20m)

Other considerations
Warranties
Most warranties in the construction industry provide coverage against latent defects. There is currently diversity in the way E&C companies account for these and other types of warranties. We expect practice to become less diverse and potentially change significantly for some entities in this area, resulting in delayed revenue recognition and complex accounting calculations for certain of these warranties. Proposed model Warranties Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. Contractors typically account for warranties that protect against latent defects outside of contract accounting and in accordance with existing loss contingency guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these Contractors are required to account for the estimated costs of rectification and guarantee work, including expected warranty costs, as contract costs. However, contractors typically (due to materiality considerations) account for standard warranties protecting against Current U.S. GAAP Current IFRS

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Proposed model The warranty is accounted for as a cost accrual if a customer does not have the option to purchase a warranty separately from the entity.

Current U.S. GAAP warranty repairs.

Current IFRS latent defects outside of contract accounting and in accordance with existing provisions guidance. A contractor will recognize revenue and concurrently accrue any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage (that is, extended warranties) and recognized over the expected life of the contract.

Revenue is deferred for warranties that protect against defects arising through normal usage (that is, extended An entity might provide a warranty that warranties) and recognized over the calls for a service to be provided to the expected life of the contract. customer (for example, maintenance) in addition to a promise that the entitys past performance was as specified in the contract. The entity will account for the service component of the warranty as a separate performance obligation in these circumstances.

Key change from the 2010 Exposure Draft: The boards originally proposed that all types of warranties, including those that provide assurance that the good or services is as specified in the contract, be accounted for as a deferral of revenue. The accounting for warranties as a separate performance obligation is now based primarily on whether the customer has the option to purchase the warranty separately and if it provides a service in addition to providing assurance that the entity's past performance was as specified in the contract, which is more aligned with todays accounting.

Example 10 - Accounting for warranties


Facts: Assume the same fact pattern as Example 7 above. The contractor also provides a warranty that covers latent defects for certain components of the oil refinery. This warranty is automatically provided by the contractor and the customer does not have an option to purchase the warranty separately from the contractor. How would the contractor account for such a warranty? Discussion: The contractor would account for this warranty as a cost accrual. Contractors who determine that cost-to-cost is an appropriate method to measure transfer of control over time might therefore have to consider these costs in their cost-to-cost calculation.

Contract costs
Existing construction contract guidance contains a substantial amount of cost capitalization guidance, both related to precontract costs and costs to fulfil a contract. The proposed standard also includes contract cost guidance that could result in a change in the measurement and recognition of contract costs as compared to today (in particular for those contractors that currently use the Gross Profit method for calculating revenue and cost of revenue). Proposed model Contract costs All costs related to satisfied performance obligations and costs related to inefficiencies (i.e., abnormal costs of materials, labor, or other costs to fulfil) are expensed as incurred. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had There is a significant amount of detailed guidance relating to the accounting for contract costs within the construction contract guidance. This is particularly true with respect to accounting for pre-contract costs. There is a significant amount of detailed guidance relating to the accounting for contract costs. Current U.S. GAAP Current IFRS

Costs that relate directly to a contract and are incurred in securing the contract are included as part of Pre-contract costs that are incurred for contract costs if they can be separately a specific anticipated contract generally identified, measured reliably, and it is

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Proposed model not been obtained and are recognized as an asset if they are expected to be recovered. As a practical expedient, such costs may be expensed as incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less. Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained (for example, certain bid costs) shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. Direct costs of fulfilling a contract are accounted for in accordance with other standards (for example, inventory, intangibles, fixed assets) if they are within the scope of that guidance. Direct costs of fulfilling a contract are capitalized under the proposed standard if not within the scope of other standards if they relate directly to a contract, relate to future performance, and are expected to be recovered under the contract. Capitalized costs are amortized as control of the goods or services to which the asset relates is transferred to the customer, which may include goods or services to be provided under specific anticipated contracts (for example, a contract renewal).

Current U.S. GAAP may be deferred only if their recoverability from that contract is probable. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance.

Current IFRS probable that the contract will be obtained. Other detailed guidance on costs to fulfil a contract is also prescribed by current guidance.

Key change from the 2010 Exposure Draft: Costs to obtain a contract were to be expensed as incurred under the original exposure draft. The boards received feedback that certain costs to obtain a contract may meet the definition of an asset and should be capitalized. The guidance was therefore revised to require recognition of an asset for costs to obtain a contract if they are incremental and expected to be recovered (unless the amortization period of the asset that the entity otherwise would have recognized is one year or less). The boards clarified that costs to fulfil a contract are in the scope of the revenue guidance only if they are not addressed by other standards and that the costs of abnormal amounts of materials, labor, and other resources that were not considered in the price of the contract should be recognized as an expense when incurred.

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Example 11 - Accounting for contract costs


Facts: Assume the same fact pattern as Example 8 above. At the beginning of the contract, the contractor incurs certain mobilization costs amounting to $1 million. The contractor has concluded that such costs should not be accounted for in accordance with existing asset standards (for example, inventory, fixed assets, or intangible assets). How should the mobilization costs be accounted for? Discussion: These costs to fulfil a contract would be capitalized if they: (a) relate directly to the contract; (b) relate to future performance; and (c) are expected to be recovered. Assuming the mobilization costs meet these criteria and are capitalized, $500,000 would be amortized as of the end of year one (coinciding with 50 percent control transfer using a cost-to-cost method) using the fact pattern in Example 8 above.

Onerous performance obligations


Existing construction contract guidance requires a loss to be recorded when the expected contract costs exceed the total anticipated contract revenue. E&C entities might be impacted by the proposed guidance in two ways. First, the proposed standard requires entities to assess performance obligations satisfied over a period of time greater than one year to determine whether they are onerous. The determination of anticipated losses will not be assessed at the contract level. E&C entities might need to recognize an onerous loss on an overall profitable contract if that contract contains separate performance obligations (for example, a design / build contract) and one of the performance obligations is determined to be onerous. Second, a performance obligation is onerous under the proposed standard if the lowest cost of settling the performance obligation, including the cost to exit the performance obligation, exceeds the amount of transaction price allocated to that performance obligation. Factoring in the cost to exit the performance obligation if lower than the remaining direct cost to fulfil it might result in fewer loss provisions recorded (or a decrease in the amount of a loss recorded in some cases) as compared to existing practice. Proposed model Onerous performance obligations An entity will recognize a liability and a corresponding expense if a performance obligation that is satisfied over a period of time greater than one year is onerous. A performance obligation is onerous if the lower of (a) the costs that relate directly to satisfying the performance obligation by transferring the promised goods or services, and (b) the amount the entity would pay to exit the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. Contracts within the scope of construction contract accounting are evaluated at the contract level. A provision for a loss on a contract is made when the current estimates of total contract revenue and contract cost indicate a loss. Contracts within the scope of construction contract accounting are assessed at the contract level. The expected loss is recognized when it is probable that total contract costs will exceed total contract revenue. Current U.S. GAAP Current IFRS

Key change from the 2010 Exposure Draft: Onerous performance obligations were to be evaluated at the performance obligation level for all performance obligations under the original exposure draft. The boards changed the guidance in response to concerns about the unintended consequences of this provision so that it only applies to performance obligations satisfied over a period of time greater than one year. Performance obligations satisfied at a point in time are not subject to the onerous test under the revised exposure draft.

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Final thoughts
The above commentary is not all inclusive. Other potential changes include, for example, the accounting for options to obtain additional goods or services and a significant expansion in disclosure requirements (with certain disclosure exceptions for private companies). The effective date of the final standard is likely to be no earlier than 2015 or 2016. The proposed standard requires retrospective application, but allows for certain practical expedients. The practical expedients are intended to reduce the burden on preparers by (a) not requiring the restatement of contracts for comparative periods that began and ended in the same accounting period; (b) allowing the use of hindsight in estimating variable consideration; (c) not requiring the onerous test to be performed in comparative periods unless an onerous contract liability was recognized previously; and (d) not requiring disclosure of the maturity analysis of remaining performance obligations in the first year of application. The FASB has proposed to prohibit early adoption, while the IASB has proposed to permit early adoption. Companies should continue to evaluate how the model might change current business activities, including contract negotiations, key metrics (including debt covenants, surety, and prequalification capacity calculations), budgeting, controls and processes, information technology requirements, and accounting.

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Dataline 18

Authored by:
H. Kent Goetjen U.S. Engineering and Construction Leader Phone: +1 (860) 241-7009 Email: h.kent.goetjen@us.pwc.com Jonathan Hook Global Engineering and Construction Leader Phone: +44 (0) 20 780 44753 Email: jonathan.hook@uk.pwc.com Dusty Stallings Partner Phone: +1 (973) 236-4062 Email: dusty.stallings@us.pwc.com Michael Sobolewski Senior Manager Phone: +1 (313) 394-3299 Email: michael.sobolewski@us.pwc.com Jason Aeschliman Senior Manager Phone: +1 (973) 236-4983 Email: jason.a.aeschliman@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.

US GAAP Convergence & IFRS Revenue recognition: Entertainment and media industry supplement

Dataline A look at current financial reporting issues


No. 2011-35 (supplement) December 6, 2011 Whats inside: Overview .......................... 1 Licenses and rights to use ............................. 2 Variable consideration... 5 Accounting for multiple performance obligations .....................7 Options to acquire additional goods or services .................... 9 Accounting for return rights ........................... 11 Contract costs ................ 12 Player points / promotion programs .. 15

Revenue from contracts with customers The proposed revenue standard is re-exposed

Entertainment and media industry supplement


Overview
The entertainment and media industry includes various subsectors, such as filmed entertainment, television, music, video games, publishing, radio, internet, and gaming. Each subsector has unique product and service offerings, and, in certain subsectors, industry-specific revenue recognition guidance exists under U.S. GAAP. IFRS does not have industry-specific guidance. The following items common in the entertainment and media industry may be significantly affected by the proposed revenue recognition standard. This paper, the examples, and the related assessments contained herein, are based on the Exposure Draft, Revenue from Contracts with Customers, which was issued on November 14, 2011. These proposals are subject to change until a final standard is issued. The examples reflect the potential effect based on the proposed standard and any conclusions noted are subject to further interpretation and assessment based on the final standard. We have also provided a highlevel summary of key changes from the original exposure draft issued on June 24, 2010 (the 2010 Exposure Draft). References to the proposed model or proposed standard refer to the exposure draft issued in November 2011 unless otherwise indicated. For a more comprehensive description of the proposed standard refer to PwC's Dataline 2011-35 (www.cfodirect.pwc.com) or visit www.fasb.org.

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Dataline

Licenses and rights to use


Many entertainment and media companies license intellectual property to third parties. Such licenses might include the right to exploit a motion picture in various markets and territories or the right to exploit a character to be used in a video game or other consumer product. Under the 2010 Exposure Draft, revenue recognition for the license of intellectual property was dependent on whether the license was exclusive or non-exclusive. Proposed model A license is a right to use, but not own, intellectual property that is granted by an entity to the customer. The recognition of revenue for the license of intellectual property is a performance obligation that is satisfied when the customer obtains control of those rights. Control of rights to use intellectual property cannot be transferred prior to the beginning of the license period. Current U.S. GAAP Sale of episodic television series in syndication Current IFRS

IFRS does not contain any industryspecific accounting for media and entertainment entities. In general, Current guidance requires that the revenue should not be recognized following conditions be met prior to the under licensing agreements until recognition of revenue: performance under the contract has occurred and the revenue has been earned. Persuasive evidence of an arrangement exists The assignment of rights for a nonrefundable amount under a nonThe film is complete, has been cancellable contract permits the delivered, or is available for licensee to use those rights freely. The immediate delivery transaction is in substance a sale when the licensor has no remaining The license period has begun and obligations to perform. the customer can begin its exploitation, exhibition, or sale A fixed license term is an indicator that the revenue should be recognized over The arrangement fee is fixed or the period because the fixed term determinable suggests that the license's risks and Collection of the arrangement fee is rewards have not been transferred to the customer. However, the following reasonably assured indicators should be considered in Delivery may occur on a daily or weekly determining whether a license fee should be recognized over the term or basis, even though all of the episodes are complete and ready for delivery, in upfront: order to allow for the insertion of advertisements into the filmed product. A contractual provision allowing the producer to insert its national advertising spots is not considered a provision that would preclude revenue recognition. The net present value of the entire syndication contract is recognized as revenue upon commencement of the license term if the criteria above are met. Licenses and right to use motion pictures It is common in certain international territories for a producer to license a film to a counterparty in several markets, such as theatrical, home video, and television. Such contracts Fixed fee or non-refundable guarantee The contract is non-cancellable Customer is able to exploit the rights freely Vendor has no remaining performance obligations When receipt of a license fee or royalty is contingent on the occurrence of a future event, revenue is recognized only when it is probable that the fee or royalty will be received, which is normally when the event has occurred.

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Dataline

Proposed model

Current U.S. GAAP typically have predefined dates when the title can be exploited in each of the markets. Each contract also typically specifies an overall minimum guaranteed payment that may be paid up front or be allocated to the various components by market. For amounts allocated to the various markets, revenue is generally recognized as each market becomes available. Although current practice is mixed, generally the license fee is allocated to the various markets (for example, theatrical, home video, and television) on a relative fair value basis and revenue is recognized when the market is contractually available for exploitation. Licenses to use a record master or music copyright The license of a record master or music copyright may be considered an outright sale if the licensor has signed a non-cancellable contract, has agreed to a fixed fee, has delivered the rights (as well as the recording) to the licensee, and has no remaining significant obligations to furnish music or records (that is, contracted recordings have been transferred). The earnings process is complete and the licensing fee is recorded as revenue if the license is, in substance, an outright sale and if collectibility is reasonably assured. If the licensor is unable to determine the amount of the license fee earned (that is, the license allows for a continued amount of additional music to be provided), the consideration received should be recognized as revenue equally over the remaining performance period, which is generally the period covered by the license agreement.

Current IFRS

Impact: Careful consideration will need to need to be given to what represents the performance obligation (for example, an episode or the series) and when control is transferred for each obligation (that is, at inception or at some later point in the contract term). The timing of revenue recognition for the license of an episodic television series, filmed entertainment, and music is not anticipated to be significantly impacted by the proposed standard. That is, in many cases, revenue for a license of intellectual property (IP) will be recognized when the customer obtains control of the content and is able to exploit the IP.

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Dataline

Proposed model

Current U.S. GAAP

Current IFRS

The licensor should estimate any variable consideration in determining the transaction price. Revenue would be recognized when the entity is reasonably assured of being entitled to the fee, which could affect the timing of revenue recognition. The licensor is not reasonably assured to be entitled to an amount of consideration from a license arrangement that is dependent on the customer's subsequent sales until those future sales occur.

Key changes from the 2010 Exposure Draft: The distinction made in the 2010 Exposure Draft between nonexclusive and exclusive licenses was eliminated during redeliberations based on feedback received by the boards. Respondents believed that revenue should be recognized when the performance obligation is satisfied regardless of whether the license is exclusive or non-exclusive. Revenue is recognized for a license that is a separate performance obligation when the customer controls and can use the intellectual property of the entity.

Example #1 - Sale of episodic television series in syndication


Facts: Studio XYZ licenses 100 of its completed episodes of an episodic television series to a cable channel for a four-year period commencing January 1, 20XX on an exclusive basis in the U.S. The cable channel pays an annual fee of $4 million in equal monthly installments and is contractually obligated to air this program each weeknight. Additionally, Studio XYZ has the right to insert two 30-second advertising spots into each airing of the show. How should Studio XYZ account for the license fee? Discussion: Today, the net present value of the payment stream is recognized as revenue when the series is available for exploitation by the cable channel. Consistent with current practice, revenue will be recognized under the proposed standard once the licensee obtains control of the property (that is, the content is available for exploitation). The impact of the time value of money will need to be assessed if the contract includes a significant financing component as the content is delivered at the beginning of the license period while the payments are made throughout the contract term.

Example #2 - Licenses and rights to use motion pictures


Facts: Studio Zed licenses certain international windows for Film A to a customer for a ten-year period in return for $10 million to be paid as follows: $4 million on theatrical availability; $4 million on the date six months after the theatrical release date (which is also the home video availability date), and $2 million one year after the theatrical release date (which is also the television availability date). The arrangement prohibits Studio Zed from licensing Film A to other parties in the same markets and territory during the original license term. How should Studio Zed account for the license fee? Discussion: Studio Zed will need to determine if one license (that is, a ten-year license for multiple windows - theatrical, home video, and television) is granted to the customer or if three distinct licenses are granted (that is, a license for each release theatrical, home video, and television). Assuming Studio Zed determines that each release is a distinct license, the transaction price of $10 million would be allocated to each license based on their relative standalone selling prices. Revenue allocated to each distinct license would be recognized once the licensee obtains control of the content and is able to exploit it under the terms of the agreement.

Example #3 - Non-exclusive license of record master or music copyright


Facts: Record Label enters into a non-exclusive license agreement with a retailer. The license allows the retailer to use Song X for two years in commercials produced by the retailer. The terms of the agreement do not require Record Label to provide the retailer with any additional content or deliverables. How should Record Label account for the license agreement? Discussion: Because Record Label has no further performance obligations under the terms of the agreement, revenue would be recognized once control of the license was obtained by the retailer as that is when the retailer can exploit Song X under the agreement.

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Dataline

Variable consideration
Many arrangements in the entertainment and media industry include minimum guaranteed payments with additional potential variable consideration in the form of royalties or other incremental payments. Management will need to assess variable consideration in determining the transaction price to be allocated to the performance obligations. Proposed model The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring goods or services to the customer, excluding amounts collected on behalf of third parties (for example, sales taxes). Current U.S. GAAP International sales of films for a minimum guarantee and potential variable upside consideration Current IFRS Revenue is recognized for a license fee or royalty that is contingent on the occurrence of a future event only when the revenue is reliably measurable and it is probable that the fee or royalty will be received, which may be when the event has occurred. Revenue would be recognized when the license is available for exploitation if the license fee or royalty is probable of being received and is reliably measurable.

A licensee may commit to pay a minimum non-refundable license fee up front in a licensing arrangement. The licensor may also include a The transaction price, including any provision stipulating that the licensor variable amounts, must be estimated at is entitled to a percentage of the contract inception and at each licensee's revenues once the variable reporting period. Any variable rate exceeds the amount of the fixed consideration should be estimated minimum guarantee. using either the expected value (based on the sum of probability-weighted The revenue associated with a nonamounts) or the most likely amount, refundable fixed minimum guarantee whichever is most predictive of the would be allocated to each market amount to which the entity will be being licensed on a relative selling price entitled. basis, and would generally be recognized once the license for that market is available for the licensee, presuming all of the revenue recognition conditions have been met. Any amounts to be paid by a licensee in excess of a fixed non-refundable minimum guarantee payment would typically be recognized by the licensor once the variable fee exceeds the total minimum guarantee (that is, the contingency is resolved). Minimum guarantees associated with a record master or music copyright Minimum guarantees received in advance by the licensor are initially reported as a liability and are recognized as revenue as the license fee is earned. If the amount of the license fee earned cannot be determined, the guarantee is recognized as revenue on a straight-line basis over the license term. Impact:

The licensor should estimate the amount of consideration it will be entitled to, including any variable consideration, in determining the transaction price. The recognition of consideration that includes variable amounts is recognized when control passes to the customer if the entity is reasonably assured to be entitled to the variable amount. The requirement to estimate variable consideration will require licensors to make subjective estimates of the transaction price that may not have been made in the past.
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Dataline

Proposed model

Current U.S. GAAP

Current IFRS

Revenue recognition that is currently restricted to only the non-contingent amount could change significantly under the proposed model, depending on the nature of the contingency. However, the proposed standard is not expected to significantly affect the timing of revenue recognition for licenses that involve variable amounts based on sales-based royalties (for example, revenue based on a percentage of product sold by a digital service provider or another third party). These amounts generally will not be recognized prior to the uncertainty being resolved.

Key changes from the 2010 Exposure Draft: The original exposure draft allowed for revenue recognition of variable amounts without constraint provided "the transaction price can be reasonably estimated." The recognition of variable amounts will now be limited to "the amount to which the entity is reasonably assured to be entitled." The transaction price will still include an estimate of variable consideration for allocation purposes similar to the 2010 Exposure Draft. Previously, this estimate was based on a probability-weighted amount. The boards received feedback that a probability-weighted approach would not be appropriate in some circumstances and as a result, changed the requirement to the more predictive of either a probability-weighted or most likely amount.

Example #4 - Licenses and rights to use motion pictures


Facts: Studio Zed enters into a contract with a customer to license certain international windows for Film A for a ten-year period in return for a minimum guarantee of $10 million plus a royalty of 10% of revenues once total revenues from exploitation of Film A exceed $100 million. The guarantee is to be paid as follows: $4 million on theatrical availability, $4 million on the date six months after the theatrical release date (which is also the home video availability date), and $2 million one year after the theatrical release date (which is also the television availability date). The arrangement prohibits Studio Zed from licensing Film A to other parties in the same markets and territory during the original license term. How should Studio Zed account for the royalty revenue? Discussion: Variable consideration is generally recognized today once the amount is earned. Variable consideration should be included in the transaction price under the proposed standard and be allocated to the separate performance obligations based on the relative estimated selling price approach, but only recognized once the entity is reasonably assured of being entitled to it. Studio Zed would not recognize the revenues associated with the royalty until they are received, as the amount is dependent on sales derived by the customer. That is, Studio Zed is not reasonably assured to be entitled to the royalty revenues until the subsequent sales occur by the licensee.

Example #5 - Non-exclusive license of record master or music copyright


Facts: Record Label enters into an agreement with a digital service provider to license the full catalog of Record Label's music content for five years. Under the terms of the agreement, the digital service provider will be entitled to current content plus any new music content added to the catalog. The terms of the license include a non-refundable minimum guarantee payable at contract inception plus a portion of future sales (that is, downloads) in excess of the minimum guarantee. How should Record Label account for license fees? Discussion: Currently, upfront revenue recognition is precluded as the label is required to provide new content throughout the term of the license agreement. Under the proposed standard, the timing of revenue recognition may change. Record Label will need to identify all performance obligations in the contract and allocate total estimated consideration to the content currently available and the content anticipated to be available during the term. Breakage will need to be considered for revenue allocated to future content. Consideration associated with the sales-based royalty will be recognized once Record Label is reasonably assured of being entitled to the amount, which will be when the future sales occur.

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Dataline

Accounting for multiple performance obligations


Performance obligations are defined as a promise to deliver goods or perform services. Determining when to separately account for these performance obligations under the proposed standard is a key determination and could require a significant amount of judgment. Management will need to determine whether performance obligations in a contract need to be accounted for separately from other performance obligations in the contract. The separation criteria might result in more performance obligations being identified than under current practice. Proposed model The model requires performance obligations that are "distinct" to be accounted for separately (assuming the performance obligations are delivered at different times). A good or service is distinct and should be accounted for separately if the entity regularly sells the good or service separately or the customer can benefit from the good or service either on its own or together with other resources readily available to the customer. A promised bundle of goods or services should be accounted for as one performance obligation if the bundled goods or services are highly interrelated such that integration services are provided and the bundled goods or services are significantly modified or customized. Current U.S. GAAP Additional functionality included in software products, including video games Certain software products (for example, console video games) provide additional functionality (such as online services and multi-player functionality) in addition to the core software. Management must assess whether the services are incidental to the overall product and is therefore an inconsequential deliverable in such arrangements. Current IFRS An entity should apply the revenue recognition criteria to each separately identifiable component of a single transaction if necessary to reflect the transaction's substance. The customer's perspective is important in determining whether the transaction should be accounted for as one element or multiple-elements. The arrangement might be accounted for as one transaction if the customer views the purchase as one element.

When elements in a single contract are accounted for separately, fair value should be used in allocating the transaction price to the separate elements. Entities would not be precluded from separating elements in a single contract if the elements are not Revenue is generally recognized ratably sold separately. over the estimated service period when the functionality is more than Impact: Multiple-element inconsequential. This is because arrangements accounted for under vendor-specific objective evidence IFRS might be affected because the ("VSOE") of fair value typically does performance obligations will need to be not exist for the online functionality, as accounted for separately if they are it is not sold separately from the game. distinct. Further, the relative estimated selling price approach will be applied in Impact: Video game developers will allocating the transaction price to the need to determine whether the video separate performance obligations game and the additional services rather than the relative fair value should be accounted for as separate allocation. performance obligations under the proposed standard. Management will need to determine whether the game and additional services are distinct performance obligations. If they are distinct, the transaction price will be allocated to the separate performance obligations. Because the video game is typically delivered at a single point in time while the services are delivered over a future service period, the timing When the additional functionality is inconsequential, revenue is generally recognized at delivery (that is, upon the transfer of the risk and rewards to the customer).

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Dataline

Proposed model

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

Current IFRS

Key changes from the 2010 Exposure Draft: The basic principle of accounting for separate performance obligations has not changed from the 2010 Exposure Draft. The boards have provided additional guidance on when a bundle of goods or services could result in a single performance obligation in an effort to better reflect the economics of certain long-term contracts.

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Dataline

The boards also revised the guidance for determining whether a performance obligation is distinct. The concept of a distinct profit margin was removed. The focus is now on whether the good or service is sold separately by the entity or whether the good can be used with other resources readily available to the customer.

Example #6 - Online functionality included in software products


Facts: Company A develops and sells video games. The video games include additional services that enhance the user experience by allowing multi-player game formats and other online services. The additional services are not sold on a stand-alone basis by Company A. Company A has historically accounted for the sale of a video game with additional services that enhance the user experience together, recognizing revenue for both the game and the services over the service period. How should Company A account for the sale of the video game and services? Discussion: Company A will need to determine if the video game and the additional services are distinct and thus, should be accounted for separately under the proposed standard. If the game and additional services are not distinct because the game cannot be used without the online services, then the contract should be accounted for as one performance obligation consistent with current practice. Revenue would be recognized over the service period.

Example #7 - Advertising arrangements


Facts: Advertiser A provides multiple forms of internet advertising to customers, including impression-based advertising and activity-based advertising both in stand-alone and in bundled arrangements. Advertiser A enters into a contract with Customer X to provide three advertising campaigns. Advertiser A will provide 100,000 click-throughs, two banners, and 50,000 impressions during the term of the contract. The total arrangement consideration is $100,000. Advertiser A has established a rate card that is to be used as a starting point in negotiating pricing. However, discounts are commonly granted to customers and the range of pricing is not consistent. Advertiser A has historically accounted for the deliverables as one unit of account when sold on a combined basis due to the inconsistency in pricing of the individual elements. How should Advertiser A account for the advertising revenue? Discussion: Advertiser A will need to consider whether the advertising campaigns included in the contract should be accounted for separately. Assuming the campaigns are delivered at different times, Advertiser A will need to assess whether the ad campaigns are distinct performance obligations. Because the ad spots are sold separately and are not dependent on one another, they are distinct and thus, the transaction price is allocated to each of the three campaigns based on their relative estimated selling prices. Revenue is recognized as the ad spots are delivered during the campaign.

Options to acquire additional goods or services


An entity may grant a customer the option to acquire additional goods or services. Often such options provide a discount on subsequent purchases. It is not uncommon in filmed entertainment to include the option to renew a series for incremental seasons. Licensors will need to determine if that promise gives rise to a material right to the customer in order to determine the appropriate accounting for the option. Proposed model An option to acquire additional goods or services gives rise to a separate performance obligation in the contract if the option provides a material right to the customer that the customer would not receive without entering into that contract. Management will need to estimate the transaction price to be allocated to the separate performance obligations based on the estimated Current U.S. GAAP Options to renew a series for incremental seasons Producers of episodic television series often enter into licensing agreements that allow the licensee to license additional seasons. The option to acquire additional seasons is usually considered to be at Current IFRS The recognition criteria are usually applied separately to each transaction (that is, the original purchase and the separate purchase associated with the option). However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction.

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Dataline

Proposed model standalone selling price of the option as, in effect, the customer is paying for future goods or services to be received. Revenue is recognized for the option when it expires or when the future goods or services are transferred to the customer. An option to acquire additional goods or services at a price within a range of prices typically charged for those goods or services is not a material right even if the option can only be exercised because of entering into the previous contract. Such an option is considered a marketing offer. Impact:

Current U.S. GAAP fair value and no allocation of consideration is made to the option.

Current IFRS If an entity grants to its customers, as part of a sales transaction, an option to receive a discounted good or service in the future, the entity accounts for that option as a separate component of the arrangement and therefore allocates consideration between the initial good or service provided and the option.

Revenue will need to be allocated to the option and deferred until delivery of the second item or when the right expires if the producer determines that the pricing for the incremental seasons provide a material right to the licensee. Renewal contracts may provide a customer with a material right to acquire future goods or services (based on the terms of the original contract) that are similar to the original goods or services. The transaction price in such options may need to be allocated to the optional goods or services based on the expected goods or services to be provided and the expected consideration to be received.

Key changes from the 2010 Exposure Draft: No significant changes from the 2010 Exposure Draft.

Example #8 - Options to renew a series for incremental seasons


Facts: Studio Star produces an episodic television series and licenses 13 episodes to be produced in season one to Network Alpha for a license fee of $1.5 million per episode. The arrangement also includes an option whereby Network Alpha, at its sole discretion, can require Studio Star to produce seasons two and three for a license fee of $2 million and $2.5 million per episode, respectively. How should Studio Star account for the option? Discussion: Studio Star would recognize revenue of $1.5 million as it delivers each episode to Network Alpha under existing U.S. GAAP. No specific accounting consideration is given to the existence of the option to acquire subsequent seasons. These options will be exercised only if Network Alpha believes that the episodic series has some reasonable level of consumer acceptance. Conversely, under IFRS, Network Alpha would need to allocate a portion of the consideration to the option and defer such amount until the right is exercised or expires. In evaluating these options under the proposed standard, Studio Star determines that the option provides a material right to the licensee because fixed pricing establishes significant upside for Network Alpha if the series becomes a "hit" (that is, if a new license was entered into, the pricing would be materially different). Therefore, the estimated transaction price for the license of the episodic television series would include the amount of consideration Studio Star expects to be entitled to from the exercise of the option to license the two additional seasons. The total transaction price would then be allocated to the performance obligations, including the future obligations related to seasons two and three.

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Dataline 10

Accounting for return rights


Return rights are common in sales transactions that include physical goods sold to retailers. Some of these rights may be articulated in contracts with customers or distributors, while some are implied during the sales process. These rights take many forms and are driven generally by the buyer's desire to mitigate technological risk or the risk that the product will not sell, and the seller's desire to promote goodwill with its customers. Proposed model Revenue should not be recognized for goods expected to be returned; rather, a liability should be recognized for the expected amount of refunds to customers. The refund liability should be updated for changes in expected refunds. An asset and corresponding adjustment to cost of sales should be recognized for the right to recover goods from customers on settling the refund liability, with the asset initially measured at the original cost of the goods (that is, the former carrying amount in inventory). Current U.S. GAAP Sales of digital or physical music Revenue is recognized for sales of physical music products (for example, compact discs) once the product is available for release (that is, at the street date), which is typically after the product has been shipped by the producer to the retailer. The amount of revenue recognized is affected by the estimated returns that are expected. Revenue is recognized for the sale of digital music once the consumer downloads the song or album. The sale of digital music does not include the right of return. Current IFRS Revenue is typically recognized at the gross amount (in full) with a provision being recorded against revenue for the expected level of returns, provided that the seller can reliably estimate the level of returns based on an established historical record and other relevant evidence.

Impact: Accounting for returns will be largely unchanged under the proposed standard. However, the balance sheet will be grossed up to include the refund obligation as a liability (not a contra-asset) and to include an asset for the right to the returned goods. The timing of revenue recognition might be affected for the sale of physical product as recognition currently occurs once the retailer has the ability to sell the product to consumers (at the street date). Recognition is predicated on the transfer of control of the performance obligation under the proposed standard. The