Adopting the New Revenue Recognition Standards Institute of

Adopting the New Revenue Recognition Standards Institute of

Adopting the New Revenue Recognition Standards Institute of Internal Auditors Northern California-East Bay, January 2018 1 ArmaninoLLP | armaninoLLP.com ArmaninoLLP | armaninoLLP.com About Our Presenters Ricardo Martinez, CPA Partner, Audit Ricardo has more than 15 years of accounting and finance experience He has held positions with KPMGs Audit Group & Global Methodology Department Member of: o American Institute of Certified Public Accountants (AICPA) o California Society of Certified Public Accountants (CalCPA) o ProVisors Graduated from Santa Clara University 2 ArmaninoLLP | armaninoLLP.com About Our Presenters

Paul Merchant, CPA Senior Manager, Governance Risk and Compliance Paul has over 13 years of accounting, finance and consulting experience. He was previously an audit and assurance manager at Crowe Horwath, with financial institution and valuation subject matter expertise. Member of: o American Institute of Certified Public Accountants (AICPA) o California Society of Certified Public Accountants (CalCPA) Graduate of Loyola Marymount University, Los Angeles 3 ArmaninoLLP | armaninoLLP.com Learning Objectives During todays presentation, participants will: Obtain a basic understanding of how to adopt the new revenue recognition standards Identify an organization's risks, from the departmental level to the valuation of the entire company Evaluate the impact of the new regulations on the internal control environment. Obtain tips for working with an auditor to streamline audits moving forward with the new standards

4 ArmaninoLLP | armaninoLLP.com Polling Questions Please indicate the ownership of your Company? 1. Non-public 2. Public Which of the following best describes your Companys current implementation status? 3. Have not started 4. Assessment phase 5.

Implementation of the standard 6. All finished, just here for some CPE 5 ArmaninoLLP | armaninoLLP.com Polling Questions Which of the following best describes the primary industry in which you operate? 1. Software 5. Professional Services 2. Real Estate

6. Non-profit 3. Technology 7. Other 4. Life Sciences Do you expect the standard to have a material impact on your Companys income statement and/or balance sheet? 5. Yes, we expect a material impact to our financial statements 6. No, we do not expect a material impact to our financial statements

7. Unsure 6 ArmaninoLLP | armaninoLLP.com Important Dates January 2018 Go live date for public companies January 2019 Go live date for private companies Early Adoption Benefit: Avoid the dual reporting requirements: If youre a pre-revenue company now, adopt the ASC 606 reporting standards and you will be in full adoption prior to the deadline. 7 ArmaninoLLP | armaninoLLP.com 5 Steps Companies will be required to follow five steps when deciding how/when to recognize revenue: 1. Identify a contract with a customer

2. Separate the contracts commitments 3. Determine the transaction price 4. Allocate a price to each promise 5. Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract 8 ArmaninoLLP | armaninoLLP.com Impact on Investors Total amount of revenue will not change Timing of revenue recognition could be very different. Many companies are expected to record revenues earlier under the new guidance. The guidance requires companies to estimate the effects of variable consideration, such as sales incentives, discounts and warranties 9 ArmaninoLLP | armaninoLLP.com Impact on the Software Industry The high hurdle of vendor-specific

objective evidence is no longer required to allocate contract consideration The unit of accounting identification criteria is revised from standalone to distinct Timing of recognizing product sold through distributors is now based on transfer of control as opposed transfer of risks and rewards Recoverable incremental customer acquisition costs such as commissions are capitalized 10 ArmaninoLLP | armaninoLLP.com Rights of return are considered a form of variable consideration that may require the allocation of a portion of transaction price Right to receive when-and-if available software may be a distinct performance obligation requiring the allocation of a portion of the transaction price Intellectual property licenses are evaluated for recognition purposes to

determine whether they are a right to use intellectual property or are granting a right to access intellectual property over the license period Rev Rec Accounting Challenge Example Vendor A sells a perpetual license to software and 2 years of support. Upgrades are if and when available Sales price is $10,000 Vendor does not have VSOE 11 ArmaninoLLP | armaninoLLP.com Accounting for the Challenge ASC 606 ASC 605 Allocate the transaction price to separate performance obligations based on their relative standalone selling prices.

Revenue is deferred when VSOE of fair value does not exist for undelivered elements. Cash Cash $10,000 $10,000 License Revenue $3,000 License Revenue Deferred Revenue - Support Amortize over 24 Months $5,000 Deferred Revenue Support Amortize over 24 Months

Deferred Revenue Upgrades $2,000 Recognize as delivered 12 ArmaninoLLP | armaninoLLP.com Deferred Revenue Upgrades Recognize when delivered -0$10,000 N/A Impact on the Real Estate Industry Home builders, developers, and property managers will need to determine whether separate performance obligations exist within their contracts. Variable consideration estimates for property management and development services may need to change. Real estate companies will need to make a judgment call on whether control of the property transfers over time or at a point in time to determine when to recognize revenue.

13 ArmaninoLLP | armaninoLLP.com Services in leasing contracts may need to be accounted for separately with a potentially different pattern of revenue recognition than the associated lease rental income. Contracts including seller-provided financing will require evaluating collectability and using judgment to determine whether there is an implied price concession or an impairment loss. Rev Rec Accounting Challenge Example Vendor enters into a contract with Customer to build an asset for $100,000. Contract contains a $50,000 performance bonus paid based on timing of completion, with a 10% decrease in the bonus for every week completion extends beyond the agreed-upon completion date. Management estimates: 30% probability of on-time completion 60% probability of one week late

10% probability of two weeks late. The entity has relevant experience with similar contracts. 14 ArmaninoLLP | armaninoLLP.com Accounting for the Challenge 606 605 Management concludes that the most likely amount method is the most predictive approach for estimating the performance bonus. Management anticipates at 1 week delay. Revenue related to variable consideration generally is not recognized until the uncertainty is resolved. It is not appropriate to recognize revenue based on a probability assessment. On date of Sale On date of Sale

Accounts Receivable Revenue On date of Delivery $45,000 $45,000 True up to actual if different than original estimate 15 ArmaninoLLP | armaninoLLP.com Accounts Receivable Revenue On date of Delivery -0- Accounts Receivable Revenue $45,000 -0-

$45,000 Impact on High Tech Manufacturing The new guidelines require complex multi-element allocation. Manufacturers will need to adjust the timing of recognizing product sold through distributors. There are significant changes to accounting for customer acquisition costs. Trade-in provisions could be treated as right of return, leases, or financing. 16 ArmaninoLLP | armaninoLLP.com High tech manufacturers have a new method for evaluation of performance obligations. The result of compliance to ASC 606 may be decreased inventory. Manufacturers are advised to create a warranty reserve (right of return).

Rev Rec Accounting Challenge Example Vendor sells $20,000 of product. Customer has 1 year to return the product if it does not meet the customers needs. Vendor does not have a returns history with this product, but does not expect returns to be more than 10% of sales. 17 ArmaninoLLP | armaninoLLP.com Accounting for the Challenge 606 605 Revenue is only recognized for goods that the entity reasonably expects will not be returned and a liability is recognized for the expected amount of refunds to customers. The refund liability is updated for changes in expected refunds.

Returns are estimated based on historical experience with an allowance recorded against sales. Revenue is not recognized until the return rights lapse if the entity is unable to reasonably estimate potential returns. On date of Sale Cash $20,000 Liability of Returns $ 2,000 Revenue $18,000 On date of Sale Cash $20,000 Deferred Revenue $20,000 Revenue -0- On date of Delivery True up to actual if different than original

estimate On date of Delivery Deferred Revenue $20,000 Revenue Cash Refunds 18 ArmaninoLLP | armaninoLLP.com $18,000 $ 2,000 Impact on the Life Sciences Industry There are now two types of licenses recognized in the new standard with different revenue recognition rules. o Right to Use o Right to Access

Complex licensing arrangements will require careful consideration to determine whether the performance obligations should be accounted for separately. Variable consideration in contracts requires estimating total transaction price and reassessing it during each reporting period. 19 ArmaninoLLP | armaninoLLP.com Royalty revenue is a form of variable consideration and will be estimated using either the expected value (probability-weighted estimate) or most likely amount approach. Sell-through approaches with distributors result in revenue being recognized when control of the product transfers to the customer. A warranty purchased separately is accounted for as a separate performance obligation.

Rev Rec Accounting Challenge Example Company A grants a right to use IP license to Company B Company A will also perform R&D on the IP. The Company A receives o an upfront payment of $20 million, o per-hour payments for R&D services performed o milestone payment of $50 million upon regulatory approval. 20 ArmaninoLLP | armaninoLLP.com Rev Rec Accounting Challenge Analysis There are 2 performance obligations o Right to use License o Performance of R&D Services Company A estimates R&D Services will be $10 million under the contract Regulatory approval is considered unlikely. Total transaction consideration is $30 million ($20M Upfront + $10M R&D) Estimated value if sold separately: Right to use License - $30 million R&D Services - $20 million. Standalone Obligation price Relative %

License 30 60 R&D 20 40 Total 50 100 21 ArmaninoLLP | armaninoLLP.com Upfront Payment 12 8 20 R&D 6 4 10 Total 18 12

30 Accounting for the Challenge 606 605 Transfer of Right-to-use License Transfer of Right-to-use License Cash Cash $20 Revenue $18 Deferred Revenue $ 2 As R&D is Delivered Cash

$12 $20 As R&D is Delivered $10 Revenue Deferred Revenue $ 2 22 ArmaninoLLP | armaninoLLP.com Revenue Cash $10 Revenue $20 $10 Impact on the Professional Services Industry Firms will need to estimate variable

consideration for contracts with elements such as incentives, awards, or penalties. Revenue for services could be recognized before acceptance (if probable and can estimate progress). Overtime recognition may require enforceable right to progress payments, or customer access to work in process (WIP). No margin normalization is allowed. Revenue is recognized upon completion for situations where progress cant be estimated. 23 ArmaninoLLP | armaninoLLP.com No milestone method is required. Rev Rec Accounting Challenge Example

Consulting firm will implement a new accounting system. Key Deliverables / Milestones are o $50,000 on completion of Phase 1 o $150,000 on completion of Phase 2 Consulting firm has a history of completing similar projects on time and on budget. Estimated time to complete is 12 months. 24 ArmaninoLLP | armaninoLLP.com Accounting for the Challenge 606 605 Contract price is considered variable consideration based on history, Consulting firm could recognize revenue based on inputs or outputs. Assuming level throughout the project, $16,667/mo. ($200,000/12)

Recognize revenue as each milestone is completed Unbilled AR $16,667 Completion of Milestone 2 Revenue $16,667 Completion of Milestone 1 Cash Revenue Cash Revenue 25 ArmaninoLLP | armaninoLLP.com $50,000 $50,000 $150,000 $150,000 Impact on the Nonprofit Industry

While every entity will soon follow the new five-step approach to recognizing revenue, nonprofits solely supported by donor contributions will not be impacted. Hybrid contracts including part donation and part exchange transaction (e.g. fundraising event tickets) will need to be bifurcated. However, nonprofits who generate earned income will need to consider the following: Nonprofits may need to identify and capitalize costs for acquiring a customer contract. A significant number of nonprofit earned revenue streams are within scope of the new standard, including: tuition, memberships, subscriptions, products and services, royalty agreements, sponsorships, conferences and seminars, advertising, licensing and

certain grants. 26 ArmaninoLLP | armaninoLLP.com Rev Rec Accounting Challenge Example Symphony has a Membership Program Members pay $60 in annual dues Members receive o a monthly newsletter - $30 value o access to the museums archives - $10 value o one free admission - $15 value o designated parking $20 value 27 ArmaninoLLP | armaninoLLP.com Rev Rec Accounting Challenge Analysis Allocate member dues to each of the 4 elements, and recognize each as delivered. monthly newsletter - $24 ($30/$75x$60) museums archives - $ 8 ($10/$75x$60) one free admission - $12 ($15/$75x$60)

designated parking - $16 ($20/$75x$60) 28 ArmaninoLLP | armaninoLLP.com Accounting for the Challenge 606 Cash 605 $60 Deferred Revenue $60 Newsletter (Monthly) Deferred Revenue $2 Revenue

Cash $2 Each as used Deferred Revenue Deferred Revenue $60 $60 Monthly $36 Deferred Revenue $5 Museums archives $ 8 One free admission $12 Designated parking

$16 29 ArmaninoLLP | armaninoLLP.com Consistent with ASC 958-605-25-1, report the entire $60 as dues revenue over the one-year membership period Revenue $5 Revenue Recognition Gap Assessment and Internal Control Updates Start Today, Sleep Better Tonight 30 ArmaninoLLP | armaninoLLP.com ArmaninoLLP | armaninoLLP.com Ripple Effect of Changes How a company records its revenue will impact many other

processes throughout the business: o Analyst & Investor Expectations o Sales o Forecasting o IT Systems Order Management Billing Credit Cost Accounting o and Internal Controls 31 ArmaninoLLP | armaninoLLP.com Planning and Documentation A comprehensive plan to address the discrepancies uncovered by the analysis: Gap analysis Potential exposure for the company Areas of the company affected by the new standard and what needs to change Impact on existing metrics as well as budgeting and forecasting Changes to contract terms and conditions High-level dates to meet the implementation and reporting deadline 32 ArmaninoLLP | armaninoLLP.com

Roadmap for Internal Control Implementation Success Complete accounting analysis m, e t s s y and y s f nti ess, nge e Id roc cha p ro l nt co s t em , y s

y f i I dent s s , and proce hanges lc c ont r o Possible dual reporting 33 ArmaninoLLP | armaninoLLP.com Test controls New GAAP Current GAAP Implementation Approach Top Control Considerations Impacting Companies General controls over system changes Application controls as information flows

through system Review of judgments and estimates Review of contract terms Review of historical data and adjustments Management review controls IT Controls Process level controls Controls over completeness and accuracy of data Controls over amended systems and processes

Controls over implementation of new accounting guidance 34 ArmaninoLLP | armaninoLLP.com Report configuration Controls over completeness and accuracy for all reports used Top Control Considerations Impacting Companies Redesign review controls over new and existing customer contracts to consider appropriate recognition and reporting under the new guidance. Implement processes for dual accounting records during the transition periods that will ensure completeness and accuracy of off-line record keeping processes. Implement controls to capture disclosure information not in existing accounting records. Update information system controls to include new risk points arising from

changes to IT systems and reports that provide data inputs used to support the new estimates, judgements and related disclosures. 35 ArmaninoLLP | armaninoLLP.com In Conclusion During this presentation, weve covered: Impact of new standards on accounting for revenue, by major industry The identification of an organization's holistic risks as they relate to the new regulations, from the departmental level such as legal, sales, internal controls and finance to the valuation of the entire company Critical areas to evaluate within the internal control environment 36 ArmaninoLLP | armaninoLLP.com What Questions Do You Have? 37 ArmaninoLLP | armaninoLLP.com

ArmaninoLLP Certified Public Accountants & Consultants Ricardo Martinez Paul Merchant 38 ArmaninoLLP | armaninoLLP.com phone: 415.276.4434 email: [email protected] phone: 415.276.4441 email: [email protected] ArmaninoLLP | armaninoLLP.com

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