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Revenue toolkit: Step five—Recognize revenue · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC.
• 0:07
  SPEAKER_02: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_02: I'm Heather Horn.
• 0:12
  SPEAKER_02: Thanks for tuning in to the next episode of our Tool Cut series, where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:26
  SPEAKER_02: For the month of March, it's all about revenue recognition.
• 0:30
  SPEAKER_02: This week, it's for the final episode in our five-part revenue recognition series.
• 0:35
  SPEAKER_03: You really can't do the analysis without knowing all of the terms in the contract.
• 0:42
  SPEAKER_01: How you account for the cost, how you recognize the cost is not explicitly linked in accounting to the amount of revenue you recognize.
• 0:50
  SPEAKER_01: So just an important to recognize the independence of revenue and cost.
• 0:56
  SPEAKER_02: Angela Ferguson, a PWC National Office partner, is, of course, back with me again.
• 1:02
  SPEAKER_02: Today she's joined by Pat Durbin, a deputy chief accountant in PWC's National Office.
• 1:07
  SPEAKER_02: And with that, let's get started.
• 1:12
  SPEAKER_02: So, Pat, Angela, thanks so much for joining me today.
• 1:15
  SPEAKER_02: We're finally at the exciting last step.
• 1:17
  SPEAKER_02: We're gonna get to recognize revenue, step five in the revenue recognition model.
• 1:23
  SPEAKER_02: And surprisingly enough, there's actually a lot more to recognizing revenue, even though we've gone through all these steps than you would think on the surface.
• 1:33
  SPEAKER_02: But before we get into some of the areas where we get the most questions and judgment, Angela, can you just give us sort of the overall background?
• 1:40
  SPEAKER_02: It's more than just recognizing a debit and a credit.
• 1:43
  SPEAKER_03: So sure.
• 1:44
  SPEAKER_03: So here we are finally at step five of our podcast series.
• 1:49
  SPEAKER_03: And I guess first, just to recap where we've been.
• 1:53
  SPEAKER_03: So starting with step one, which is identifying the contract, and then step two, which is identifying the performance obligations in that contract.
• 2:03
  SPEAKER_03: Step three is determining the total transaction price, which we then allocate to the performance obligations in step four.
• 2:12
  SPEAKER_03: So now in step five, we determine how to recognize revenue for each of those performance obligations.
• 2:20
  SPEAKER_03: And the principle here is that revenue is recognized when performance obligations are satisfied by transferring control of a promised good or service to the customer.
• 2:33
  SPEAKER_03: So control becomes very important in determining when you recognize revenue.
• 2:39
  SPEAKER_03: And control is the ability to direct the use of and obtain substantially all the remaining benefits from a good or service.
• 2:49
  SPEAKER_03: And we'll get back to that as well because there are some indicators in the standard to help determine when that occurs.
• 2:56
  SPEAKER_03: But importantly, control is either going to transfer over a period of time or at a single point in time.
• 3:03
  SPEAKER_03: And so that's going to be an important determination to identify when to recognize revenue.
• 3:11
  SPEAKER_02: All right.
• 3:11
  SPEAKER_02: So then, Angela, that sounds like probably a good place to start, and we can go back to some of the control questions.
• 3:17
  SPEAKER_02: So, what are the key determinations or key determinants in figuring out whether control transfers over time or at a point in time?
• 3:26
  SPEAKER_03: So, like everything else, we have some criteria to look at for that.
• 3:30
  SPEAKER_03: And there are three criteria in the standard.
• 3:34
  SPEAKER_03: And in this case, if you meet any of these three criteria, control transfers over time.
• 3:40
  SPEAKER_03: If you don't meet any of the three criteria, the control is going to transfer at a point in time.
• 3:47
  SPEAKER_03: So the three criteria are first of all, that the customer simultaneously receives and consumes the benefits from the vendor's performance.
• 3:59
  SPEAKER_03: So a lot of services are going to fall in this category because the customer is essentially receiving the benefit of the service as the vendor performs.
• 4:10
  SPEAKER_03: And then another way to think about this is whether another vendor could hypothetically step in and take over the performance obligation and complete it without having to reperform what the vendor already did to date.
• 4:28
  SPEAKER_03: And if you can answer yes, you know, someone else could step in and complete this performance obligation, then that would indicate that the customer is receiving and consuming the benefits as the company performs.
• 4:45
  SPEAKER_03: So then the second criteria is that the vendor's performance creates or enhances an asset that the customer controls.
• 4:56
  SPEAKER_03: So this is a little less common, but what this is getting at is if the customer controls the asset the entire time that the vendor is performing, then control of that asset or the service transfers over time.
• 5:13
  SPEAKER_03: So maybe a classic example here is if the customer owns a piece of land and then the vendor builds something on that piece of land, the customer effectively controls that work and process as the vendor is performing.
• 5:32
  SPEAKER_03: And then the last criteria is that the vendor's performance creates an asset that has no alternative use and has an enforceable right to payment for performance completed to date.
• 5:47
  SPEAKER_03: So that's a mouthful there.
• 5:50
  SPEAKER_03: But what an example of this is a highly customized product.
• 5:55
  SPEAKER_03: And the idea is that if that highly customized product has no alternative use to the vendor, they can only use it to satisfy the contract with the customer, and they're sort of protected by having right to payment as they perform, then control of that product actually transfers to the customer as it's being manufactured.
• 6:21
  SPEAKER_03: So those are the three criteria.
• 6:23
  SPEAKER_03: And just to re reiterate again, if none of those are met, revenue is recognized at a point in time.
• 6:31
  SPEAKER_02: So Angela, just to clarify that then, so if one of them is met, then it would not be point in time.
• 6:38
  SPEAKER_02: It would be overtime.
• 6:39
  SPEAKER_03: Correct.
• 6:40
  SPEAKER_03: Okay.
• 6:40
  SPEAKER_03: You only have to meet one, and typically you will only meet one criteria.
• 6:45
  SPEAKER_03: There's potential for some overlap, but oftentimes you're going to meet just one of those criteria.
• 6:50
  SPEAKER_02: All right.
• 6:50
  SPEAKER_02: So then Pat, turning to you, is there one of these criteria where we get the most questions?
• 6:57
  SPEAKER_01: Well, I think it's definitely that last one that Angela mentioned, this idea of no alternative future use and right to payment.
• 7:06
  SPEAKER_01: That's certainly where we probably had the most questions during the implementation phase.
• 7:11
  SPEAKER_01: And I'd say it's still one of the more judgmental areas.
• 7:15
  SPEAKER_01: I think Angela mentioned you see this where you have highly customized products, something you're making for a customer that's very specific to their needs and therefore can't be easily repurposed to fill any other anyone else's needs.
• 7:33
  SPEAKER_01: And it was especially challenging because a lot of traditional, you might have called widgets that people produced, but they were very specific to a customer specifications.
• 7:44
  SPEAKER_01: Think of like packaging that's labeled specific to that end customer's products and brand.
• 7:51
  SPEAKER_01: You can't just sell that to someone else.
• 7:54
  SPEAKER_01: So the idea is you're really performing and creating something that only that customer can use.
• 8:01
  SPEAKER_01: And most of the time, for that reason, you're going to want to be protected, saying, Well, I've decided to make this because you've asked me to.
• 8:11
  SPEAKER_01: I'd expect to be compensated if for whatever reason you choose not to ultimately take the end product.
• 8:19
  SPEAKER_01: So that's where the right to payment concept comes in, is you're looking for that protection.
• 8:25
  SPEAKER_01: And in effect, the customer sort of buying it all the way along.
• 8:30
  SPEAKER_01: But you really have to dig in and understand like the right to payment question, because it's not simply that you get reimbursed for the cost you've incurred, because a lot of cost um contracts might have that sort of protection in there for termination purposes.
• 8:48
  SPEAKER_01: The concept here is you have a right to be compensated for the sales value of the work you've performed at any point during the product.
• 8:56
  SPEAKER_01: So it's your cost plus a reasonable profit margin in those cases.
• 9:01
  SPEAKER_01: And that sometimes is very clear from the contracts, other times it's going to require a bit more analysis and legal interpretation, um, particularly sometimes depending on the jurisdiction in which you're operating.
• 9:18
  SPEAKER_02: So I feel like anytime I I talk to uh revenue experts about revenue recognition, there is obviously a lot of focus on this question if it's overtime or point in time.
• 9:31
  SPEAKER_02: And the examples are always around this like overtime.
• 9:35
  SPEAKER_02: What are some like simplistic examples of things that are point in time?
• 9:40
  SPEAKER_02: Is that like if I'm selling like oranges to a grocery store or like something you know that is just you have a good, you sell it, the other person takes control of it?
• 9:51
  SPEAKER_01: Yeah, I I would say most goods are going to end up being point in time.
• 9:55
  SPEAKER_01: It's more the exception where you have this highly customized goods because a lot of goods are made to some sort of specification or to customer order, but the custom the company or the the manufacturer, the producer has sort of standard types of goods that they make and they could just sell it to someone else.
• 10:14
  SPEAKER_01: It's not really so specific to that one customer that they'd be swept up in this this guidance.
• 10:21
  SPEAKER_01: And importantly, you have to have both things, right?
• 10:23
  SPEAKER_01: You have to have that customization as well as the right to payment.
• 10:28
  SPEAKER_03: Well, also I'd say though that services aren't automatically overtime.
• 10:33
  SPEAKER_03: I mean, there are some services where uh you know you're you're sort of creating a final product, and even though you might think of it as a service, you don't meet any of those criteria.
• 10:44
  SPEAKER_03: It's really the final product that you're transferring to the customer, and so you end up in point in time.
• 10:51
  SPEAKER_02: So that all said, let's go back to overtime.
• 10:54
  SPEAKER_02: And let's say you do determine that some the control is transferring over a period of time or over time.
• 11:00
  SPEAKER_02: So, what is then the guidance for how the revenue is recognized?
• 11:03
  SPEAKER_02: What's your pattern of recognition?
• 11:06
  SPEAKER_03: Yeah, so once you conclude control transfers over time, you're then going to have to choose a measure of progress towards satisfying that performance obligation, and that's going to determine your pattern of revenue recognition.
• 11:21
  SPEAKER_03: We used to call this percentage of completion accounting, so people may be familiar with that terminology, but now we focus on measure of progress.
• 11:32
  SPEAKER_03: And the guidance is not prescriptive on what that measure of progress should be, but it does give some examples.
• 11:39
  SPEAKER_03: So this includes what they call output methods, which is recognizing revenue based on a direct measurement of the value being transferred to the customer.
• 11:50
  SPEAKER_03: So that might be contract milestones, if those milestones reflect the value being transferred to the customer.
• 12:00
  SPEAKER_03: But you do need to be careful here because just because something is a billing milestone doesn't necessarily mean it's reflecting the progress or performance of the vendor.
• 12:11
  SPEAKER_03: Another example is something like an engineering survey of the progress of some sort of complex piece of equipment or something that could be used to demonstrate the value that's been transferred to date.
• 12:26
  SPEAKER_03: On the other hand, there are input methods that recognize revenue based on the resources consumed or the efforts expended by the vendor.
• 12:37
  SPEAKER_03: So an example here is the cost that the vendor has incurred compared to the total estimated costs to complete the contract.
• 12:49
  SPEAKER_03: And I'd point out here that the method is not just a pure accounting policy election.
• 12:55
  SPEAKER_03: You're supposed to select the method that best depicts the transfer of control.
• 13:01
  SPEAKER_03: And that method should be consistently applied if you have arrangements with similar performance obligations and similar facts and circumstances.
• 13:12
  SPEAKER_02: So, Angela, I noted that glaringly absent from the choices you gave there was straight line recognition.
• 13:19
  SPEAKER_02: So, how does that how does that fit in?
• 13:21
  SPEAKER_03: Yeah, so straight line is really a time-based measure of progress.
• 13:26
  SPEAKER_03: And you might think of that as an output measure if the customer is receiving value evenly over time, or you might think of it as an input measure if the vendor's efforts are expended evenly over time.
• 13:42
  SPEAKER_03: And there are definitely situations where a time-based measure would be appropriate.
• 13:46
  SPEAKER_03: And one common example is when the vendor has what we call a stand-ready obligation to perform over some stated period of time.
• 13:57
  SPEAKER_03: And a classic example that you always hear on this is a membership to a health club, where the customer has the ability to access the health club at any time over, say, a one-year membership period.
• 14:12
  SPEAKER_03: So, in that case, a time-based measure would likely make sense for revenue recognition.
• 14:18
  SPEAKER_03: Another example would be like unlimited access to a software as a service or SaaS platform for some specified period of time.
• 14:30
  SPEAKER_03: But I would contrast that to situations where the customer has a fixed amount of something that then gets used up over time.
• 14:41
  SPEAKER_03: So going back to those examples, the health club, if the customer didn't get unlimited access but got like 30 visits to the health club, you would likely recognize revenue as they used up those 30 visits.
• 14:57
  SPEAKER_03: Or with the SAS example, if the customer got a fixed amount of usage that then got depleted over time, it probably would not make sense to use just a time-based measure or straight line recognition.
• 15:15
  SPEAKER_02: So, Angela, not to get too specific on the accounting for health club memberships, but if you had that case where let's say health club and you had 30 visits, so you're gonna recognize some third or 30th each time they visit, but you know your customers come like only 10 times a month.
• 15:33
  SPEAKER_02: Do you take that into account when you're trying to figure out your pattern?
• 15:37
  SPEAKER_03: Yeah, that's that's what we refer to as breakage.
• 15:40
  SPEAKER_03: So there is a concept that if that you do estimate breakage and take that into account, you would recognize the breakage as they use the other, as they use the 10 visits, you'd recognize revenue for the full 30.
• 15:55
  SPEAKER_03: But that would be an estimate that you would have to make and apply that variable consideration constraint that we talked about in step three.
• 16:04
  SPEAKER_03: Even though it's not technically variable consideration, it's the same concept of if reaching that threshold of it being probable, you're not going to have to reverse revenue in the future.
• 16:16
  SPEAKER_02: All right, that's helpful.
• 16:17
  SPEAKER_02: And then Pat, maybe bringing you in, any other areas where you are you see judgment in um this when we're looking at sort of these measures of progress?
• 16:28
  SPEAKER_01: Well, I think other than the time-based one, there's going to be judgment involved because you really need to think about how whatever measure you're using really reflects your progress towards satisfying the performance obligation.
• 16:42
  SPEAKER_01: One of the more common overtime measures of progress that we see is the one Angela described as the ratio of costs incurred to total estimated costs.
• 16:52
  SPEAKER_01: So we usually shorthand that as cost to cost.
• 16:56
  SPEAKER_01: And so there's a couple of things that are important to think about there.
• 16:59
  SPEAKER_01: One is what is that estimate of total cost?
• 17:02
  SPEAKER_01: And you do need to be continually refreshing that.
• 17:05
  SPEAKER_01: And it's more complicated when you get into like the construction, engineering construction, maybe longer term.
• 17:12
  SPEAKER_01: So the classic, kind of old-fashioned percentage of completion, there can be a lot of judgment in those cost estimates.
• 17:19
  SPEAKER_01: Um, the other important point there is that we're using this ratio of cost incurred to total estimated costs.
• 17:27
  SPEAKER_01: And in many cases, those costs that you're incurring will or do need to be recognized in expense in the period that they're incurred, regardless of the amount of revenue you conclude you should recognize based on your measure of progress.
• 17:45
  SPEAKER_01: So it's sort of an independent analysis that you're using the cost to measure the progress toward completion of the performance obligation, but the accounting for the costs are independent.
• 17:57
  SPEAKER_01: They're either going to follow expense recognition or there's some scenarios where they might be capitalized.
• 18:02
  SPEAKER_01: But importantly, the revenue that you determine then is also kind of independently recognized.
• 18:08
  SPEAKER_01: You know, we're not sort of trying to find a constant margin throughout the project.
• 18:13
  SPEAKER_01: And I guess the other maybe just thing to watch out for is there's generally a sense that having an overtime model with sort of consistent revenue makes it a lot easier to forecast your business, talk to you know your user community about how the business is doing, but it it can't be just a set it and forget it exercise, right?
• 18:36
  SPEAKER_01: You need to be continually monitoring this and you can get some, therefore, uneven revenue, even if you're in an overtime model.
• 18:44
  SPEAKER_02: So, Pat, you may tell me this is a topic for a whole other um podcast, but when you were talking about percentage of completion sort of that traditional, I know one of the issues was always, well, then you could have these contracts are actually going through loss contracts, you get to some point.
• 18:59
  SPEAKER_02: So, how does that fit in?
• 19:02
  SPEAKER_02: I I know you were talking about costs here.
• 19:04
  SPEAKER_02: So if I have I'm performing, but I know I'm losing money, does that go to my revenue recognition at all?
• 19:10
  SPEAKER_02: Or I still follow my revenue recognition, but I have to think about recording that loss a different way.
• 19:16
  SPEAKER_01: There is guidance on recording the loss if the overall contract is going to be a loss.
• 19:23
  SPEAKER_01: And it's a little bit weird because some of that is legacy guidance that was sort of retained when um the new revenue standard came out.
• 19:31
  SPEAKER_01: And it's only certain contracts where you sort of get into that scenario.
• 19:36
  SPEAKER_01: It's a bit less clear for other contracts that you think you may be in a loss.
• 19:40
  SPEAKER_01: But importantly, even if you conclude you have a loss, you're still going to continue to recognize revenue as you perform.
• 19:48
  SPEAKER_01: It's not like you're just gonna, you know, sort of um, you know, charge revenue to the reserve, or you know, you're still gonna have revenue for that performance as you perform.
• 19:58
  SPEAKER_02: All right.
• 19:58
  SPEAKER_02: So I think key there probably is just for people to know it's out there that if they're in that situation, go look more at this this guidance, which I'm sure you guys will tell me at the end.
• 20:07
  SPEAKER_02: It's in our revenue guide.
• 20:09
  SPEAKER_02: So, Angela, um I was about to ask you then if there's anything else people should be thinking about here, practical expedients or otherwise.
• 20:19
  SPEAKER_03: Yeah, before we leave leave this topic, I do want to mention a practical expedient that relates to being able to recognize revenue based on the company's right to invoice.
• 20:32
  SPEAKER_03: So this expedient can only be used if the right to invoice corresponds directly to the value being transferred to the customer.
• 20:42
  SPEAKER_03: So it's a little bit of a shortcut because you can just recognize revenue based on what you're invoicing.
• 20:47
  SPEAKER_03: So that sounds really great, right?
• 20:49
  SPEAKER_03: Because that's operationally going to be easier, but you do need to make sure that that right to invoice does correspond directly to the value being transferred to the customer and that you really do meet that criteria.
• 21:03
  SPEAKER_03: So, for example, you usually could not apply that if the contract has significant upfront payments or the right to invoice is based on something like achieving milestones that aren't directly lining up with the performance to date.
• 21:20
  SPEAKER_03: So one example of this is like a standard time and materials contract where there's rates for you know the individuals perfor the employees that are performing and the materials that are being used up.
• 21:34
  SPEAKER_03: And if you're consistently billing based on those rates, then you may be able to apply this practical expedient.
• 21:42
  SPEAKER_01: Yeah, and I would say that's one that sort of to me always comes with a bit of a health warning.
• 21:47
  SPEAKER_01: I mean, I think the example Angela gave, that's really like kind of the classic example.
• 21:52
  SPEAKER_01: And I think what was sort of in mind when they came up with this expedient.
• 21:56
  SPEAKER_01: So if it's not something that's that straightforward, I would just say proceed.
• 22:00
  SPEAKER_01: With caution if you're thinking about applying it.
• 22:04
  SPEAKER_02: All right.
• 22:04
  SPEAKER_02: So let's go back to point in time recognition.
• 22:07
  SPEAKER_02: And obviously I had a few questions about that before, too.
• 22:10
  SPEAKER_02: But you mentioned specifically that if we don't meet any of the criteria for overtime, then you would recognize revenue at a point in time.
• 22:19
  SPEAKER_02: But then importantly, it's what is that point in time that you would recognize the revenue?
• 22:25
  SPEAKER_03: So I said, you know, before control is important in this step, right?
• 22:29
  SPEAKER_03: So the point in time that we are recognizing revenue is the point in time that control transfers to the customer.
• 22:37
  SPEAKER_03: And just again, to reiterate what control means, it's the ability to direct the use of and obtain substantially all of the remaining benefits from a good or service.
• 22:48
  SPEAKER_03: It's often a good in this case, but not always, as we said earlier.
• 22:53
  SPEAKER_03: So the standard does have five indicators to help identify when a customer has obtained control of an asset.
• 23:03
  SPEAKER_03: And this is a situation where we don't have criteria or requirements, these are actually just indicators.
• 23:11
  SPEAKER_03: So you do not have to meet all of these to conclude that control has transferred.
• 23:17
  SPEAKER_03: And just to quickly tick through the five indicators the first is that the vendor has a present right to payment.
• 23:26
  SPEAKER_03: The second is that the customer has obtained legal title to the asset.
• 23:32
  SPEAKER_03: The third is that the customer has physical possession.
• 23:36
  SPEAKER_03: The fourth is that the customer has the significant risks and rewards of ownership.
• 23:42
  SPEAKER_03: And then the last indicator is that the customer has accepted the asset.
• 23:49
  SPEAKER_02: So then, Pat, as we think about these five indicators, are there any that if I was trying to think this through, I would say are more important or that I would give more weight to?
• 24:00
  SPEAKER_01: So specifically according to the standard, no.
• 24:04
  SPEAKER_01: Um, and I guess I would just say the key here is to remember the principle, because the way the standard really works is you recognize revenue when control transfers, the principle, as Angela articulated, ability to direct the use of and retains or obtain substantially all the remaining benefits.
• 24:22
  SPEAKER_01: If that's clear, then you know when you are transferring control, right?
• 24:28
  SPEAKER_01: The indicators are helpful if it's perhaps not as clear as to when control transfers.
• 24:34
  SPEAKER_01: And if we're talking about goods, title is obviously an important one because title usually carries with it lots of legal rights to that good.
• 24:44
  SPEAKER_01: That usually is evidence of ownership.
• 24:47
  SPEAKER_01: So it oftentimes does go hand in hand with control, but you know, it's not always the case.
• 24:53
  SPEAKER_01: You you there could be situations where you don't have title and you could still be considered to have control of the inventory because there's really nothing else that can happen to that inventory without or that good without your direction, and whatever the ultimate economic benefits or or or um rights that you get from that good are going to annure to you as the customer, you can have control without having title.
• 25:22
  SPEAKER_01: Um, and as I mentioned, you know, you have to go through all of them, none are um individually determinative.
• 25:29
  SPEAKER_01: Um, one example um specifically that we see where you might not have possession or where the customer might not have possession, but you've concluded that control is transferred as what we refer to as a bill and hold transaction.
• 25:44
  SPEAKER_01: Now, once upon a time, bill and hold transactions were sort of almost categorically out of bounds and very, very narrowly accepted.
• 25:54
  SPEAKER_01: The standard we have now specifically contemplates the notion of a bill and hold.
• 25:59
  SPEAKER_01: There are specific criteria that need to be met, but usually it's still very special circumstances where, in fact, the customer says, I it's so important for me for you to have this prepared that I'm willing to pay you for it.
• 26:14
  SPEAKER_01: Um I it's definitely going to become my good.
• 26:18
  SPEAKER_01: No one else can use it.
• 26:19
  SPEAKER_01: It needs to be segregated by you.
• 26:22
  SPEAKER_01: In some cases, you might even expect to see there being some additional performance obligation to store the inventory.
• 26:28
  SPEAKER_01: But in those scenarios, even though the customer doesn't have possession, in many cases the vendor still has possession, you could get to a conclusion that control has transferred.
• 26:37
  SPEAKER_01: But it's definitely a little bit more of an exceptional circumstance than anything that uh you know would be kind of routine.
• 26:45
  SPEAKER_02: So, Pat, before you go on, because as soon as you said bill and hold, I thought, oh, you're gonna tell me you can't do this.
• 26:51
  SPEAKER_02: Uh, which clearly you said there are limited circumstances.
• 26:55
  SPEAKER_02: Is can you give an example where you've seen this, or is it that exceptional that we really just don't see it?
• 27:01
  SPEAKER_01: No, I think you would see it like it will come up a lot of times in the um context of where perhaps you're building a large facility and there are some significant pieces of equipment that have long production times, but need to be available when the job site is ready.
• 27:21
  SPEAKER_01: And it's oftentimes difficult to get that synced up.
• 27:24
  SPEAKER_01: So if you're the vendor that's producing one of these goods, you've gone and prepared it, you've got a lot of working capital invested in it, you might expect that the contract would entitle you to say to the customer, Hey, this is done, it's set aside, it's segregated, I now expect you to pay me for it, even though your job site isn't ready.
• 27:44
  SPEAKER_01: Um so I think that's a case where you could definitely see it occurring.
• 27:47
  SPEAKER_02: There's Yeah, I can see how that would make sense.
• 27:50
  SPEAKER_02: Like if you're building a huge power plant, there's some huge components you need.
• 27:54
  SPEAKER_02: You don't want to be waiting and you know, you want to make sure that they're going to be ready for you, but you don't you can't have them delivered yet.
• 28:01
  SPEAKER_02: So that actually makes a lot of sense.
• 28:03
  SPEAKER_01: The one other place I'll just mention where you know the the sort of physical possession comes into play is in the consignment space.
• 28:11
  SPEAKER_01: And that's sort of the the inverse.
• 28:13
  SPEAKER_01: It's sort of like the the potential customer or potentially eventual customer does have physical possession, but they don't have control because I've can only consigned the goods to them.
• 28:25
  SPEAKER_01: I could still decide to pull them back and redirect them to somewhere else.
• 28:29
  SPEAKER_01: So they they really don't have control, even though they have possession.
• 28:33
  SPEAKER_02: All right.
• 28:34
  SPEAKER_02: So then let's talk in a little more detail.
• 28:37
  SPEAKER_02: So if I go back to you, Angela, how about in terms of repurchase rights?
• 28:42
  SPEAKER_02: How do we see that impact revenue recognition?
• 28:46
  SPEAKER_03: Yeah, so repurchase rights are another example where the customer could have physical possession, but not yet have or never have control of that good.
• 28:59
  SPEAKER_03: And I'll just walk through at a fairly high level the guidance on repurchase rights.
• 29:04
  SPEAKER_03: And there are three different types of repurchase rights.
• 29:07
  SPEAKER_03: So one is when the vendor has an obligation to repurchase a good in the future, which is a forward.
• 29:15
  SPEAKER_03: The second is when the vendor has the right to repurchase a good in the future, which is a call option.
• 29:23
  SPEAKER_03: And the third is when the customer has the right to put the good back to the seller, which is a put option.
• 29:32
  SPEAKER_03: So at a high level, a forward or a call option, when the vendor has the right, this usually results in accounting for the arrangement as either a lease, they're really only giving the customer the right to use the asset for a period of time, or it could be a financing arrangement if the repurchase price is higher than the original selling price.
• 29:55
  SPEAKER_03: But importantly, the vendor hasn't really transferred control because of this right to repurchase the good in the future.
• 30:04
  SPEAKER_02: So that's the same question I asked Pat.
• 30:07
  SPEAKER_02: Can you give any examples of these types of arrangements?
• 30:11
  SPEAKER_03: Well, I'd say it's not pervasive by any means, but I'd say some of the times we see it is in industries where uh vendor is selling a large piece of equipment, or it's common with some automobile sales to have these kinds of repurchase rights.
• 30:30
  SPEAKER_02: All right.
• 30:30
  SPEAKER_02: And then you I noticed you explained what a put option was, but then you didn't tell us about the accounting.
• 30:35
  SPEAKER_02: So what if a customer does have the right to put the good back to the vendor?
• 30:41
  SPEAKER_03: So there's an extra bit of analysis when you're looking at a put right or a put option.
• 30:47
  SPEAKER_03: And that's because you have to assess whether the customer has a significant economic incentive to exercise that right.
• 30:56
  SPEAKER_03: Um so if the customer does have a significant economic incentive to put the asset back to the vendor, then you either have a lease or a financing arrangement similar to the evaluation of call options.
• 31:11
  SPEAKER_03: However, if the customer does not have a significant economic incentive, then that put right is really just the same as a right of return.
• 31:23
  SPEAKER_03: So then you account for the arrangement as a sale with a right of return, and you would estimate returns as variable consideration, like we talked about uh during the step three podcast.
• 31:36
  SPEAKER_02: All right.
• 31:36
  SPEAKER_02: So then, Angela, it seems like the true key there is the significant economic incentive.
• 31:42
  SPEAKER_02: So, how would you think about that?
• 31:45
  SPEAKER_03: Well, you know, the guidance says that the vendor has to consider various factors, right?
• 31:50
  SPEAKER_03: But it does specifically say that if the put price, so what the customer will receive for putting back the good, is expected to significantly exceed the fair value of the good at that time, you know, when they would put it back, then that would indicate that they would have a significant economic incentive to put it back because they're gonna get that higher price.
• 32:15
  SPEAKER_03: But I'd say in general, for repurchase rights, there's not gonna be a blanket answer because you really have to understand like why did the parties negotiate this repurchase right?
• 32:27
  SPEAKER_03: Uh, it also may depend on the type of good we're talking about, and there may be other reasons why a customer may or may not, you know, want to put that good back to the vendor in the future.
• 32:42
  SPEAKER_01: You know, and another tricky area, I mean, we don't see it all that often, but it can sometimes come up as when some of these rights are conditional upon something else happening, meaning they don't even become operative or operational in the contract until something else happens.
• 32:59
  SPEAKER_01: And there really isn't much help at all in the guidance for those those situations.
• 33:05
  SPEAKER_01: So we we really just kind of have to go back to the principle of who has control of the the good or the asset in those cases, that idea that you can direct the use.
• 33:16
  SPEAKER_01: And usually in this case, it gets down to more of the um obtaining substantially all the remaining benefits.
• 33:22
  SPEAKER_01: You know, if you're essentially going to be in control of that asset for substantially all of its economic life, then um you can usually conclude that you know control has transferred, even though there's some conditional repurchase right that might exist.
• 33:38
  SPEAKER_02: Um so then one of the last factors we talked about was this idea of acceptance clauses.
• 33:44
  SPEAKER_02: So, Pat, how would we think about those in making this assessment?
• 33:50
  SPEAKER_01: It's important to understand the the terms of the acceptance clause.
• 33:54
  SPEAKER_01: In some cases, the acceptance clause will be sort of dependent upon objective criteria that the vendor could assess that they've complied with.
• 34:07
  SPEAKER_01: You know, if there's a set of specific operating parameters that a piece of equipment needs to meet, they've tested it at their facility, and that's really the only basis on which the customer could reject the equipment, they could likely conclude that, well, I've tested it, I know it meets those conditions, that acceptance is perfunctory, and I don't really need to delay transfer of control until I formally receive that acceptance.
• 34:35
  SPEAKER_01: In other cases, and you might see this in some more custom applications, probably larger dollar value purchases, where the customer has more significant discretion in the acceptance clause.
• 34:50
  SPEAKER_01: They're going to perform their own tests, they're sort of subject to ultimately their discretion, their determination.
• 34:58
  SPEAKER_01: And if the contract permits them to essentially refuse to accept the good and not pay, then you would likely conclude the control doesn't transfer until that acceptance has been received.
• 35:12
  SPEAKER_02: All right.
• 35:13
  SPEAKER_02: So definitely I can think of some other scenarios where that would come in.
• 35:15
  SPEAKER_02: So definitely another thing to pay attention to.
• 35:18
  SPEAKER_02: So as we then think more broadly about step five, Angela, any other areas that you where you see questions coming up that we haven't hit?
• 35:27
  SPEAKER_03: Yeah, one thing we should touch on is licenses of intellectual property or licenses of IP, because there's special guidance that applies to licenses.
• 35:38
  SPEAKER_03: And in this case, whether you're recognizing revenue at a point in time or over time actually depends on the type of IP that's being licensed to the customer.
• 35:51
  SPEAKER_03: So if you're licensing the right to use functional IP, which is IP that has significant standalone functionality, and this would include things like software or media content or drug formulas, then revenue is recognized at a point in time.
• 36:12
  SPEAKER_03: On the other hand, if you are licensing the right to use what we call symbolic IP, and that would include things like brands, logos, and franchise rights, then revenue is recognized over time.
• 36:28
  SPEAKER_03: And this is based on the theory that because the IP does not have significant standalone functionality, you can't just immediately do something with it, if you will, then the utility from that IP or the value really comes from the licensor's past or ongoing activities.
• 36:52
  SPEAKER_03: But in this case, the they decided to draw this bright line between the different types of IP so that you don't have to actually like prove out whether or not the licensor is performing those ongoing activities.
• 37:05
  SPEAKER_02: And then Angela, I remember that you and Alex two weeks ago in step three talked about a special exception for royalties related to licenses.
• 37:14
  SPEAKER_02: So how does that fit into what you just shared?
• 37:18
  SPEAKER_03: Yes, yeah, I know you always make us go back on our promise to revisit the.
• 37:22
  SPEAKER_03: Exactly.
• 37:23
  SPEAKER_03: Um yeah, there so then there is also a sales or usage-based royalty, I guess I'll call it exception here for revenue recognition for licenses of IP.
• 37:37
  SPEAKER_03: And to um remind everyone what that is, is that if the vendor or the licensor is receiving royalties related to a license of IP, you cannot recognize that royalty or you're constrained in recognizing revenue until the future sale or usage occurs that the that generates the right to the royalty.
• 38:01
  SPEAKER_03: So an example is your licensing IP that a customer is using in its product.
• 38:06
  SPEAKER_03: So this would be functional IP in this case.
• 38:09
  SPEAKER_03: And so you know, so the performance obligation is satisfied at a point in time.
• 38:15
  SPEAKER_03: However, if the fee is in the form of a royalty that's based on a percentage of that customer's subsequent sales, you cannot recognize that royalty until those subsequent sales occur.
• 38:30
  SPEAKER_03: So uh, but importantly, this is not necessarily just when that royalty is received or even reported to you, it's when the sales occur.
• 38:39
  SPEAKER_03: So there may be a requirement to uh estimate royalties if, for example, you're receiving reporting on a lag basis because you're trying to uh match the period that the sales actually occur.
• 38:54
  SPEAKER_03: And again, I think I made this point also in the step three podcast, but this is an exception, so it applies only to royalties from licenses of IP, and you can't analogize to analogize as a guidance to other types of royalties or usage-based fees.
• 39:11
  SPEAKER_01: All right.
• 39:12
  SPEAKER_01: Yeah, and I'd maybe just double down on a couple of points there, Angela.
• 39:16
  SPEAKER_01: One was that it's when the royalty is determinable based on that future sale, right?
• 39:22
  SPEAKER_01: So sometimes you might see arrangements that have maybe some like run-out period where the remaining there's going to be royalties due in the remaining periods, but based on sort of a measured royalty of sales in some earlier periods.
• 39:37
  SPEAKER_01: So once you know what those sales were, and then it's just a matter of time until those royalties become payable, you would recognize them even though they're not currently going to be received in in cash.
• 39:50
  SPEAKER_01: And the other thing I would just point out is sometimes you see royalties in combination with an upfront payment.
• 39:57
  SPEAKER_01: The upfront payment is gonna follow the base model that Angela described for the type of IP that it is.
• 40:03
  SPEAKER_01: So if it's functional, it's gonna be upfront, even though those royalties are gonna come over time.
• 40:08
  SPEAKER_01: Conversely, if it was symbolic IP, you might have an upfront and a royalty.
• 40:12
  SPEAKER_01: Well, that upfront is going to be spread over time, as are the royalties.
• 40:15
  SPEAKER_01: So it's just important to make sure you know what kind of an arrangement it is and sort of what the nature of the consideration is.
• 40:23
  SPEAKER_03: Yeah, and that's it's also gonna be true for a minimum royalty.
• 40:27
  SPEAKER_03: So if it's if the it's structured as a royalty, but there is a minimum amount that the vendor is going to be due, then it's not under the exception.
• 40:36
  SPEAKER_03: That's just treated as similar to a fixed fee.
• 40:40
  SPEAKER_02: So my key takeaway from all of this particular discussion is for any arrangement, you got to make sure you know all your details.
• 40:47
  SPEAKER_02: I think that's probably a fair point that you guys would make because it's you know, there's there's definitely a lot to think about here.
• 40:55
  SPEAKER_02: So with that said, I guess we're at final wrap-up point.
• 41:00
  SPEAKER_02: So I'm curious what key takeaways you both have.
• 41:03
  SPEAKER_02: And Pat, I'll go to you first.
• 41:05
  SPEAKER_01: Well, I know Heather, you always like to go back to your roots in the uh utilities industry sometimes.
• 41:11
  SPEAKER_01: So I'll I'll go back to my roots in the um engineering construction industry.
• 41:16
  SPEAKER_01: And I mentioned this concept of using cost to cost as a measure of progress.
• 41:21
  SPEAKER_01: And just importantly, unlike the old days, that's an independent calculation of the amount of revenue you're going to recognize based on that measure.
• 41:31
  SPEAKER_01: So you're going to use that to determine your revenue.
• 41:33
  SPEAKER_01: How you account for the cost, how you recognize the cost is not explicitly linked in accounting to the amount of revenue you recognize.
• 41:42
  SPEAKER_01: So just an important to recognize the independence of revenue and cost.
• 41:47
  SPEAKER_02: All right, good reminder there.
• 41:49
  SPEAKER_02: And Angela, how about from you?
• 41:51
  SPEAKER_03: Well, mine is kind of building on what you said, Heather, is your takeaway.
• 41:56
  SPEAKER_03: And the way that us revenue folks like to say this is you know, you need to read the final contract, right?
• 42:03
  SPEAKER_03: And you you really can't do the analysis without uh knowing all of the terms in the contract because there are definitely contract terms that could impact both whether you're in point in time or over time, as well as you know, when control transfers.
• 42:20
  SPEAKER_03: And so things like repurchase rights, acceptance clauses, you become very important when you're uh doing this analysis.
• 42:29
  SPEAKER_02: Well, it sounds like Angela, also probably good to know that your salespeople who understand the details of all your contracts as you're doing that analysis as well.
• 42:38
  SPEAKER_02: Make sure you understand the full business perspective there.
• 42:43
  SPEAKER_03: Yes, always a good point.
• 42:44
  SPEAKER_02: All right.
• 42:45
  SPEAKER_02: So then with that said, where should our listeners go for more information?
• 42:51
  SPEAKER_03: We cover step five of the model in chapter six of our revenue guide, which is our revenue from contracts with customers guide.
• 42:59
  SPEAKER_01: All right.
• 43:00
  SPEAKER_01: And I think you promised earlier we'd tell people where the cost guidance is.
• 43:03
  SPEAKER_01: Do we know where that is, Angela, in the revenue guide?
• 43:06
  SPEAKER_02: Yeah, contract costs are covered in chapter 11 of our and we'll make sure we put links to that as well as to chapter six in the show notes.
• 43:14
  SPEAKER_02: So good memory there, Pat.
• 43:16
  SPEAKER_02: All right.
• 43:16
  SPEAKER_02: I was too excited thinking about the next segment, which is, as you guys both know, my favorite, which is dump the guests.
• 43:23
  SPEAKER_02: I have to say, last time the two of you were on, I think you got them both right.
• 43:26
  SPEAKER_02: So I think the producers made them a little harder today.
• 43:30
  SPEAKER_02: So just warning you now.
• 43:32
  SPEAKER_02: Um, so first one is a little serious, and then we will have a little more fun with the second one.
• 43:38
  SPEAKER_02: Revenue recognition has held the top spot of SEC fraud enforcement actions in recent years, comprising approximately 40% of cases brought by the SEC's enforcement division.
• 43:49
  SPEAKER_02: Name any of the six most common areas cited by the Center for Audit Quality as schemes involving inappropriate revenue recognition.
• 44:00
  SPEAKER_02: Any guesses?
• 44:01
  SPEAKER_03: I know we always learn those in our fraud courses.
• 44:04
  SPEAKER_01: It's like uh I think I had my accounting courses when uh you know fraud was still considered to be a evil, dishonest thing.
• 44:14
  SPEAKER_01: We didn't even think we had to worry about it.
• 44:16
  SPEAKER_01: Uh I'll go with uh channel stuffing.
• 44:19
  SPEAKER_03: Yeah, that's a good one.
• 44:21
  SPEAKER_02: All right.
• 44:22
  SPEAKER_02: And I will share all the answers, but you did get one correct.
• 44:25
  SPEAKER_02: So you are one for one.
• 44:27
  SPEAKER_02: That that is one of the six.
• 44:28
  SPEAKER_02: So good job, Pat.
• 44:33
  SPEAKER_02: Fact check.
• 44:35
  SPEAKER_02: Great work meeting my challenge to name one of them, Pat.
• 44:39
  SPEAKER_02: In addition to channel stuffing, the other five include falsifying customers or their contracts, accelerating revenue in a current period, even though all revenue recognition criteria are not met, recognizing revenue when inventory was shipped on consignment, failing to account for extended terms, concession or discount side arrangements, or finally percentage at completion.
• 45:12
  SPEAKER_02: All right, so this next one is a little more fun, but you have to pay attention.
• 45:16
  SPEAKER_02: So the cruise ship industry is starting to finally pick back up.
• 45:20
  SPEAKER_02: And as you may know, some of the world's biggest shipmakers recognize revenue for building their cruise ships over time.
• 45:27
  SPEAKER_02: It's not surprising based on the discussion we just had.
• 45:30
  SPEAKER_02: So these are big contracts for big ships that take a very long time to build.
• 45:35
  SPEAKER_02: Recently, the world's biggest cruise ship set sail, has room for almost 7,000 passengers as well as 2,300 crew.
• 45:43
  SPEAKER_02: There's 16 decks, 20 restaurants, four pools, and almost 3,000 cabins.
• 45:48
  SPEAKER_02: So the question, just can't wait to hear how you guess.
• 45:52
  SPEAKER_02: How long was it from when the contract was signed to build the ship until it was delivered?
• 45:58
  SPEAKER_02: Any guesses?
• 45:59
  SPEAKER_03: Well, probably got delayed by COVID.
• 46:03
  SPEAKER_03: Probably took even longer than normal.
• 46:05
  SPEAKER_03: Maybe I'll say two years.
• 46:09
  SPEAKER_01: I'm gonna go seven.
• 46:11
  SPEAKER_02: All right.
• 46:11
  SPEAKER_02: I will share the answer with our our listeners.
• 46:14
  SPEAKER_02: Good guesses.
• 46:19
  SPEAKER_02: Fact check.
• 46:20
  SPEAKER_02: Sorry, Angela and Pat.
• 46:22
  SPEAKER_02: Your guesses were just a little too low and a little too high.
• 46:27
  SPEAKER_02: The correct answer is over five years.
• 46:30
  SPEAKER_02: The ship is the wonder of the seas, and according to several news outlets, the initial contract to build was signed in May 2016 and was delivered in October 2021.
• 46:46
  SPEAKER_02: As always, very nice to have you both on.
• 46:49
  SPEAKER_02: Thanks so much for joining me.
• 46:50
  SPEAKER_02: Thanks for having us.
• 46:55
  SPEAKER_02: That's our show for today.
• 46:57
  SPEAKER_02: Join us back here for four special episodes where we provide context and then discuss some of the accounting issues stemming from the conflict arising from the Russian government's invasion of Ukraine.
• 47:09
  SPEAKER_02: So that you never miss any of our audio content, follow the PWC Accounting Podcast series wherever you listen to podcasts.
• 47:17
  SPEAKER_02: From Thought Leadership at PWC, I'm Heather Horn.
• 47:20
  SPEAKER_02: Thanks for tuning in.
• 47:30
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