Step 1: Identify the contract | Revenue Recognition and ASC 606

okay let's move

to step one so first we have to

the contract

the customer and the first thing you're

looking at here is what what is a

customer contract what customer contract

is an arrangement where there are

legally enforceable obligations rights

and obligations between two or more

parties so that doesn't necessarily have

to be a written contract between a

vendor and a customer could be a verbal

arrangement and implied arrangement

obviously it's much easier to evidence

that there's you know legal

enforceability when you have a written

contract but you're not limited to that

from a standpoint of determining whether

a customer contract exists also think

about today's guidance there's a notion

that you have to have persuasive

evidence of an arrangement before

recognizing revenue slice of evidence of

an arrangement is based on the typical

way that a company does business

so if company always gets a contract and

they say we don't have persuasive

evidence until both parties sign well

then you can't recognize revenue until

both parties sign that arrangement

whereas under this guidance it's based

on the notion of legal enforceability so

you may have a situation where even

though both parties haven't signed there

may be legally enforceable so you might

have a situation where you have a

contract with a customer under the new

guidance prior to when you would have

persuasive evidence under today's

guidance so that that could in some

cases result in earlier recognition now

when you're evaluating legal

enforceability of an arrangement one

thing you're looking at is you know what

are the the termination provisions in

the contract so if you had a situation

where either party could cancel a

contract at any point in time without

any termination penalty illegally if

there are no legally enforceable rights

and obligations C the party can get out

of a contract nothing is is it forcible

if there's no termination penalty so in

that case the company could cancel

either party can cancel right away you

don't have a contract to account for at

that point if we switch that up a little

bit let's say you have an arrangement

for multiple years and the first year

cause both the customer and the vendor

are locked in so they can cancel but in

year two or year three they're allowed

to terminate without a without a penalty

so just today's guidance you would look

at that generally as a three year

under the new guidance what you'd say is

well you're evaluating the legal

enforceability and so in that

arrangement the only portion that's

legally enforceable is year one either

party can cancel in year two or year

three so therefore you would only

account for that arrangement it has a

one-year contract you'd look at year two

and three no different than you would a

situation where a company has an option

to renew in year two or three so you'd

look at it as a one-year contract

essentially with with two years of

options now you may have to those

options may be what are considered

material rights that have to be

accounted for but you wouldn't say I

have a full three year contract in that

situation and that could have an impact

in a number of areas particularly when

you have multiple performance

obligations it might impact the amount

of the total transaction price allocated

to each performance obligation which as

we'll see as we go through the model and

impact the the amount that is recognized

as revenue now we're talking about

contracts with customers it's not

necessarily each individual contract

that has to be accounted for separately

if there are situations where contracts

are entered into multiple contracts are

entered into a Dornier at the same time

those will be may need to be accounted

for together and what the guidance says

is well you look - you may have to

combine those contracts and account for

them together if any of the three

criteria we have listed here are met so

I think that today's guidance actually

has a rebuttable presumption when you

sign contracts a tourney at the same

time that they should be count accounted

for as a package unless that presumption

is overcome this guidance is not as

strict but I think in many cases it will

result in the same thing or the same

accounting because if you look think

about these criteria the first one is

that where the contracts negotiated as a

package and share the same commercial

objective in most cases when you have

two parties negotiating multiple

contracts it will be hard to argue that

those multiple contracts were not

negotiated as a package if they're

signed at or near the same time so I

think in many cases you're going the

results going to be accounting for them

as a package now what's going to be

judgmental in is judgmental today is

what's meant by contract

or near the same time there's no bright

lines on that so companies will have to

kind of make that evaluation of what

sort of timeframe they look to that's

considered at or near the same time so

that's going to be very based on

company's particular facts and

circumstances there is also a practical

expedient and you'll see as we talk to

through the presentations today there

are quite a few practical expedients and

policy elections included in the

guidance and a lot of these are included

to be helpful from an implementation

standpoint to make it a little bit

easier on the general start going to be

very easy but some of these practical

expedients policy elections will will

help that can this practical expedient

says that well if you have a number of

different contracts that are similar

types of contract you may be able to put

them all together so these aren't one

signed a tourney at the same time these

are just contracts in general let's say

you have thousands of homogeneous

contracts again and says well a prize of

practical expedient you can account for

them as a portfolio if it's not expected

to result in a materially different


so the issue here as well to evaluate

whether something is not going to result

in a materially different outcome

question is do I have to account for it

separately and see if it would be

different and that wasn't the board's

intentions and this is more of a

qualitative evaluation to see if they

won't accounting for them together won't

result in a materially different outcome

but that is something that will be you

know companies lots of support ok so

just because you have an arrangement

with legally enforceable rights and

obligations doesn't necessarily mean

that you are passed step one so you have

to meet these five contract existence

criteria to actually move past step one

into the rest of the model so a number

of these I think in many cases will be

will be straightforward when you have an

arrangement with legally enforceable

rights and obligations so looking at

those commercial substance exist so is

it you know is it not essentially a sham

transaction you have to look closer it's

situations where certainly where there

are related party arrangements to make

sure there is some sub substance and

there's an expectation that cash flows

will change approval have been obtained


commitment on the part of both parties

so I have to make sure that this is not

a situation where you're typically well

maybe have a signed contract you have a

lot of if you have a lot of situations

where companies will back out of those

arrangements you don't follow up with

them on that or your customers back out

you have to make sure that that's that's

not the case and there is a commitment

to perform rights and payment terms are

identifiable so it's clear to both

parties what those their rights and

payment terms are and then finally

collection of the amount to which the

entity will be entitled is is probable

we'll talk about collection a little

more on the next slide but the way

collection is evaluated is a little bit

different under the new guidance in that

it's really kind of a gating question

under the new guidance you have to

support that collection is probable to

even move throughout the rest of the

model whereas today it's more when

you're evaluating collection it's more

of a more of a measurement issue I would

say now if you meet all these criteria

you you generally don't have to

re-evaluate them going forward so let's

say you're performing under a contract

you don't have to consistently

continuously look at these five criteria

to make sure they're still met but if

they're in a significant change in

circumstances you do have to re-evaluate

them so let's say there's a situation

where you met all the five criteria and

you're performing a dermal two-year

contract and then six months into the

contract you're the customer has some

significant financial problems and yet

you think that maybe collections not no

longer probable so in that situation you

would have to reevaluate that and if you

concluded that well now collection is no

longer probable you wouldn't it wouldn't

have any impact on the revenue you've

already recognized but what it would

impact is going forward you would say

well I'm no longer under the model so

unless I meet certain criteria I can't

recognize any revenue in the future also

you would have to evaluate any contract

asset or receivable that you recorded as

a result of the your initial accounting

for this contract so let's talk a little

bit about collectability and there's

some some kind of nuances here when

we're talking about about collectability

so what you're looking at is is it

probable that the customer is going to

pay substantially all of the

the consideration you'll be entitled to

for the promised goods and services you

going to transfer to the customer so you

don't have to look at whether you're

going to Colette has not going to be

probably you're going to collect a

hundred percent of the amounts just has

to be probably you're going to collect

substantially all and again no bright

lines there but certainly as you're in

the higher 90s of expectation of what

you'll collect that's likely to meet

this substantially all criteria the

other thing to think about here is well

you're looking at the promised goods or

services that will be transferred and I

think we're the kind of the nuance here

is that the promise conservator that

will be transferred aren't necessarily

all of the promise goods or services in

the contract and so we'll walk through

an example of where you may have a

situation where you're not going to be

evaluating the entire transaction price

for a for a particular contract and

determining if it's collectible you

might be evaluating less than that that

amount which is which would be a

difference from today where when you're

evaluating collectability you're always

evaluating the the full price in the

arrangement now this is going to involve

a judgement in some cases and the reason

the reason for that is as you'll see as

you'll see in when we get to step three

on transaction price step three

considers a notion of implied price

concessions so there's going to be it

can be difficulty of evaluating whether

if situation where you don't collect

whether that's considered an implied

price concession that reduces

transaction price or if it's considered

bad debt and the impact of that would be

if it's collectability issue bad debt

you record that as that expense whereas

if you have an implied concession that's

actually recorded as a reduction of your

transaction price and a redundant which

becomes a reduction of of revenue so

your starting point for evaluating

collectability as you look at you look

at your transaction price and so even

though transaction price is in step

three you kind of have to peek ahead and

evaluate that transaction price first as

you're doing step one and transaction

price we'll go through this in detail

later it includes a number of number

of different things including your fixed

cash consideration it includes

significant financing components it also

includes variable consideration it's a

variable consideration might be you know

any changes in the potential changes in

the amount you expect to receive so that

could be through bonuses it could be

through penalties it can be as a result

of discounts can also be as a result of

what I just mentioned earlier implied

concessions and so a typical example

that you might see on an how you would

look at an implied concession might be

in the healthcare industry so let's say

you have a situation with a hospital

they're building their patients and even

though the standard rate for a patient

might be $10,000 they look at that and

say well we're going to build this

patient who doesn't have insurance their

self pay 10,000 but really really going

only going to try to collect 3,000 so in

that case they wouldn't have a situation

where they say well that $7,000

difference is bad debt that would

generally be considered an implied price

concession and so their transaction

price wouldn't be 10,000 it would be

3,000 so from a collectability

standpoint you're starting off you'd

only evaluate that that 3,000 for

collectability not the 10 you can see

how that would be a significant

difference because they had to evaluate

to 10,000 and likely would mailed say

collections is probable whereas with the

3,000 there's a higher likelihood

they'll be able to say that collection

is probable now when you're looking at

collectability though you don't just

stop there it might be a lower amount

you evaluate for a collectability and

this is where the kind of notion of

looking at the goods or services that

will be transferred comes into play and

so an example of this might be let's say

you have a one-year contract one-year

service contract with a customer you

know that customer is not the most

creditworthy customer so your mitigating

your credit risk as a vendor what you're

doing is you say okay I will provide you

customer one year of services however I

need you to pay me for the first two

months upfront and then I'm not going

I'm not going to perform until you make

those payments and then in months 3

through 12 at the beginning of each

month prior to performing prior to doing

the service I need you to pay me upfront

so the

vendor has mitigated their credit risk

there is no way they're going to provide

some services without getting paid for

those services before they provide them

so in this case even though the

transaction price will be based on 12

months of services and at 12 month price

when you're evaluating what the amount

that's probable of collection you're

only going to look at the amount that

relates to the goods or services that

will be transferred and you only know

the goods and services that will be

transferred to those first two months

because you've been paid upfront if you

don't get paid at the beginning a month

3 you're not going to transfer you know

continue performing your services in

month 3 so in this case you're only

evaluating to 12 so 2 months out of 12

for collectability not to full 12 months

because you know you're going to stop

performing those services after month 2

if you're not paid so in that situation

you're going to say well of course

collection is probable because I've

collected upfront and so I meet the

collectability criteria whereas if you

couldn't just say if you have to

evaluate the full 12 months given this

customer is not the most creditworthy

you wouldn't have been able to conclude

that you need to step one criteria so if

you meet step one criteria you move on

to to step two and the rest of the model

that we'll discuss if you don't meet the

criteria but then the question becomes

well what do I do if I get some upfront

payment what do I do with that payment

if I don't meet step 1 well initially

what you have to do is you have to

record a liability for that payment and

you would continue to evaluate whether

you as you go forward whether you meet

whether you meet that step one criteria

if you do then you can start applying

the rest of the model if you don't so

you don't continue not meeting that's

step one criteria there's only a couple

of circumstances in which you can

actually take that liability even if

it's not refundable and actually

recognize it as revenue before meeting

to step one criteria and so you'll have

some differences from today because

today what you'll do if you get

non-refundable cash and you've performed

on part of an arrangement that relates

to that cash you can recognize generally

recognize that revenue even if you're

continuing to perform other services for

that customer because it's a

non-refundable and you perform under the

new guidance is there are three criteria

one of three

kyria that'd have to be one of three

events I should say that has to be met

to recognize that on refundable cash so

you might have a situation under the new

guidance where you're including an

amount as a liability and not recognize

it recognizing it as revenue for longer

than you do under under today's guide so

here are the three events that if they

occur you can recognize that

non-refundable cash even though you

haven't passed step one so the first one

says that well if I don't you know if

I've received an order fundable cash

there's no performance obligations I've

performed on everything I have to and

I've collected substantially all the

amounts promised then I can recognize

well now it's not all that helpful

because that's basically the end of the

contract right so it would be if you

couldn't recognize it then it would be

even harsher because there's nothing

left to be done the second one would be

its contracts been terminated and there

are questions as the after the guidance

was initially written of or published

what do you mean by termination is that

legal termination is that a situation

where you know what if I continue to try

to collect is it not considered

terminated then so because of those

questions to bore the faz be decided to

add a third a third event subsequent to

the initial issuance of ASU 2014

Illinois so this third event says okay

if you've had non-refundable cash you

transfer the related goods or services

that that cash consideration relates to

and you're not going to transfer any

goods and services in the future and

aren't obligated to you could recognize

that non-refundable cash and so this is

still stricter than today's guidance

because under today's guidance if you

got the non-refundable cash and you

perform related to that even if you have

additional goods and services you're

going to transfer you can still

recognize that non-refundable cash ins

revenue under this new guidance if

you're continuing to perform even though

you've gotten under fundable cash and

performed on the amounts for the goods

and services relating to that cash you

would still have to defer that as a

liability until you do not have any

future goods and services that you're

going to transfer so that's why I said

earlier you may have situations under

the new guidance that you have to

that non-refundable cash longer than you

do today

okay last item before we move on step

two is on contract modifications and the

good thing about this new model is

they're there excuse me the new guidance

one of the good things is that there is

a model for contract modifications today

there's really no model for contract

modifications and a debtor account for

them except under certain guidance like

the contract accounting guidance so

today there are always questions well if

I change your contract do I apply that

on a retrospective basis or do a

cumulative catch up and adjust revenue

today or do I just account for it

prospectively and so there's a number of

situations that the model for

modifications addresses we're not going

to get through them in any detail but

the impact is there's a couple of things

that will impact your conclusion here

one was the weather change is approved

so do you have something that meets the

definition of a contract when you have

that modification I'm you're going to

look at the pricing so is it priced

they're new goods and services added was

the pricing added standalone selling

price or not you're going to look at the

the new goods or services that are added

are they considered distinct from the

goods or services you had in the old

contract and we'll talk about whether

goods and services are distinct in step

two but that all have a significant

impact and so ultimately there can be

depending on the facts and circumstances

there could be three different results

one you might account for the

modification just as a as a separate

contract so this will be the case if you

added some goods or services that were

considered distinct and your pricing is

at its normal standalone selling price

so I would just be prospective treatment

as a separate contract another scenario

might be you have to account for the

arrangement has basically modification

essentially as terminating the old

contract and entering into a new

contract so that situation might be when

you add some goods or services but you

don't price them out they're standalone

selling price so that would still be

prospective treatment but the difference

from the county for a separate contract

would be you're going to take your

remaining performance obligations from

the original contract

added to the new goods and services or

performance obligations and reallocate

your total you total fee or your total

transaction price the last bucket that

you could fall into is that you do a

cumulative catch-up adjustment so if you

have a situation where you add some

goods and services they're not distinct

what you would do in that situation is

you just account for the modification on

a cumulative catch-up basis so you'd say

well how much revenue did I recognize to

date how much would I have recognized

had this modification existent on day

one the difference between those two

would be an adjustment to your your

revenue at the point in time when the

contract modification is is approved so

I think it will be helpful to have an

actual model under the new guidance

compared to today where there really

really is no model