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Internal Audit, Risk, Business & Technology Consulting

THE NEW REVENUE RECOGNITION AND LEASE ACCOUNTING STANDARDS OUR APPROACH TO A SUCCESSFUL TRANSITION

Institute of Internal Auditors (IIA)

Austin, TX

November 14th, 2017

© 2017 Protiviti Inc. An Equal Opportunity Employer M/F/Disability/Veterans. Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services. All registered trademarks are the property of their respective owners.

AGENDA FOR TODAY

Revenue From Contracts With Customers (ASC Topic 606)

Lease Accounting (ASC Topic 842)

Transition Approach and Diagnostic Elements

Appendix – Our “9 Step” Diagnostic Approach

2

REVENUE FROM CONTRACTS WITH CUSTOMERS


Core Principle:

Revenue recognition depicts transfer of promised goods or services to customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services

NEW REVENUE RECOGNITION STANDARDOverview

4

• Final Standard Released May 28, 2014

− As expected, on July 9, 2015 the Financial Accounting Standards Board (FASB) approved a one-year deferral of the effective date of the new revenue recognition standard it has developed in collaboration with the International Accounting Standards board (IASB)

− IASB also delayed the IFRS 15 adoption by 1 year to be aligned with the FASB

• Transition Approaches

− Retrospective, or

− Cumulative effect at the date of adoption

• Objective of project

− Achieve a single, comprehensive revenue recognition model

• Removes existing industry specific guidance

• Expands qualitative and quantitative disclosures

• Still a lot of uncertainty on the impact of this new standard


NEW REVENUE RECOGNITION STANDARDFive Step Framework

5

Identify the contract(s) with a customer1

Identify the performance obligations in the contract 2

Determine the transaction price3

Allocate the transaction price to the performance obligations in the contract

4

Recognize revenue when (or as) the entity satisfies a performance obligation

5


HIGH-LEVEL APPLICATION OF REVENUE MODEL IN FIVE STEPS

Identify the contract(s) with a customer1• A contract is an agreement between two or more parties that creates enforceable rights and

obligations.

6

• In some cases, an entity should combine contracts and account for them as one contract. In addition, there is guidance on the accounting for contract modification.

• An entity should apply the requirements to each contract that meets the following criteria:

– Approval and commitment of the parties

– Identification of the rights of the parties

– Identification of the payment terms

– The contract has commercial substance

– It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer



7





4


5



Identify the performance obligations in the contract 2• A performance obligation is a promise in a contract with a customer to transfer a good or

service to the customer. If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a performance obligation only if it is (1) distinct or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer.

8

• A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that are distinct.

• A good or service is distinct if both of the following criteria are met:

– Capable of being distinct – 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.

– Distinct within the context of the contract – The promise to transfer the good or service is separately identifiable from other promises in the contract.



9





4


5



Determine the transaction price3• The transaction price is the amount of consideration (for example, payment) to which an

entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. To determine the transaction price, an entity should consider the effects of:

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– Constraining estimates of variable consideration – An entity should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

– Variable consideration – If the amount of consideration in a contract is variable, an entity should determine the amount to include in the transaction price by estimating either the expected value (that is, probability-weighted amount) or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled.



Determine the transaction price (contd.)3– The existence of a significant financing component – An entity should adjust the

promised amount of consideration for the effects of the time value of money if the timing of the payments agreed upon by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing for the transfer of goods or services to the customer.

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– Noncash consideration – If a customer promises consideration in a form other than cash, an entity should measure the noncash consideration (or promise of noncash consideration) at fair value.

– Consideration payable to the customer – If an entity pays, or expects to pay consideration to a customer in the form of cash or items (for example, credit, a coupon, or a voucher) that the customer can apply against amounts owed to the entity, the entity should account for the payment (or expectation of payment) as a reduction of the transaction price or as a payment for a distinct good or service (or both).



12





4


5



Allocate the transaction price to the performance obligations in the contract4• For a contract that has more than one performance obligation, an entity should allocate

the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.

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• To allocate an appropriate amount of consideration to each performance obligation, an entity must determine the standalone selling price at contract inception of the distinct goods or services underlying each performance obligation and would typically allocate the transaction price on a relative standalone selling price basis. If a standalone selling price is not observable, an entity must estimate it. Sometimes, the transaction price includes a discount or variable consideration that relates entirely to one of the performance obligations in a contract. The requirements specify when an entity should allocate the discount or variable consideration to one (or some) performance obligation(s) rather than to all performance obligations in the contract.



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4


5



Recognize revenue when (or as) the entity satisfies a performance obligation5• An entity should recognize revenue when (or as) it satisfies a performance obligation by

transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service.

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For each performance obligation that an entity satisfies over time, an entity shall recognize over time by consistently applying a method of measuring the progress toward complete satisfaction of that performance obligation. Appropriate methods of measuring progress include output methods and input methods. As circumstances change over time, an entity should update its measure of progress to depict the entity’s performance completed to date.

• For each performance obligation, an entity should determine whether the entity satisfies the performance obligation over time by transferring control of a good or service over time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.


Disaggregation of Revenue

Information about Contract Balances

Contract Costs

Information about Performance Obligations

Description of Significant Judgments

Policy Decisions –TVM and Costs to Obtain a Contract

Transaction Price Allocation Methods and

Assumptions

Remaining Performance Obligations

Disclosures

OTHER PROVISIONS

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NEW REVENUE RECOGNITION STANDARDTransition and Effective Date

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Transition Method 2016/2017 2018

Full Retrospective Restate these periods for all contractsApply new revenue standard to all contracts

Cumulative Effect at the Date of Adoption

These periods not restated for any contracts

Apply new revenue standard to new and existing contracts; disclose effect of applying new standard


EARLY ADOPTERSEarly Adopters of ASC Topic 606

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Raytheon

Ford MotorsUnited Health Group

General Dynamics

Alphabet, Inc.

Workday

First Solar

Microsoft

Of the thousands of SEC Registrants, only six (6) have early adopted the FASB’s new revenue recognition standard as of January 1, 2017. Two (2) other SEC Registrants have planned early adoptions for February 1, 2017 and July 1, 2017, respectively.

Modified Retrospective Modified RetrospectiveModified Retrospective Full Retrospective

Full Retrospective Full Retrospective Full Retrospective Full Retrospective


EARLY ADOPTERSExample Disclosures from Selected Early Adopter SEC Filings

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“We adopted ASU 2014-09 in the first quarter of 2017 using the full retrospective method. This adoption primarily affected our systems business sales arrangements previous accounted for under ASC 360-20, which had required us to evaluate whether such arrangements had any forms of continuing involvement that may have affected the revenue or profit recognition of the transactions, including arrangements with prohibited forms of continuing involvement. When such forms of continuing involvement were present, we reduced the potential profit on the applicable project sale by our maximum exposure to loss. Our adoption of ASU 2014-09, which supersedes the real estate sales guidance under ASC 360-20, generally requires us to recognize revenue and profit from our systems business sales arrangements earlier and in a more linear fashion than our historical practice under ASC 360-20, including the estimation of certain profits that would otherwise have been deferred.”

“ASC Topic 606. We adopted ASC Topic 606 on January 1, 2017, using the retrospective method. The adoption of ASC Topic 606 had two primary impacts on our Consolidated Financial Statements. The impact of adjustments on profit recorded to date is now recognized in the period identified (cumulative catch-up method), rather than prospectively over the remaining contract term. For our contracts for the manufacture of business-jet aircraft, we now recognize revenue at a single point in time when control is transferred to the customer, generally when the customer accepts the fully outfitted aircraft. Prior to the adoption of ASC Topic 606, we recognized revenue for these contracts at two contractual milestones: when green aircraft were completed and accepted by the customer and when the customer accepted final delivery of the fully outfitted aircraft. The cumulative effect of the adoption was recognized as a decrease to retained earnings of $372 on January 1, 2015.”

ACCELERATED

DECELERATED


NEW REVENUE RECOGNITION STANDARD

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Q&A

LEASES


THE NEW LEASE STANDARD – BIG PICTURE

Applicable to all entities: public, private, and not-for-profit, whether large or small. It applies to all leases, including subleases, other than the following:

• Leases of intangible assets

• Lease to explore for or use minerals, oil, natural gas, and similar non-regenerative resources

• Lease of biological assets, including timber

• Leases of inventory

• Leases of assets under construction


THE NEW LEASE STANDARD – BIG PICTUREWhat your financial statements will look like

Finance

Operating

Here’s how the model will be reflected for Lessee:

Balance Sheet

Right-of-use asset Lease liability

Right-of-use asset Lease liability

Income Statement

Front-loaded• Amortization

expense• Interest expense

Lease cost

Cash Flow Statement

Financing• Principal

Operating• Interest• Variable

payments

Operating

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THE NEW LEASE STANDARD – BIG PICTURE

Effective Date

Public Business Entities: The amendments in ASU 2016-02 are effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early adoption is allowed.

Non-Public Business Entities: Should apply the amendments for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020, for a calendar year entity), and interim periods within fiscal years beginning after December 15, 2020. Early adoption is allowed.


THE NEW LEASE STANDARD – BIG PICTURETransition

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“Modified retrospective” application must be applied. It is required for all leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements.

Transition Method: Transition Guidance:

A company must apply the guidance at the beginning of the earliest period presented in a set of financial statements for substantially all leases outstanding at initial application.

For example, 2017 data is needed for adoption in 2019 for calendar-year-end public companies.

Note: Practical expedients are provided.

*


THE NEW LEASE STANDARDA Closer Look – Accounting and Financial Reporting Impacts

26

Separate the Components of a Contract

ReassessModified Leases

Determine if a Contract

is or Contains a Lease

Calculate the discounted PV

of lease payments

Identify Lease

Attributes

Classify the

Lease

Measure and

Record the Lease

Financial Statement

Disclosures


THE NEW LEASE STANDARDA Closer Look – Accounting Impacts

27

Determine if a contract

is or contains a lease

How do you know if you have a lease? A lease is present if the contract includes…

The right to control the asset during the lease term

Decision-making authority over the use of the asset

The ability to obtain substantially all economic benefits from use of the asset

An identified asset

Is explicitly or implicitly specified

Supplier has no practical ability to substitute or would not economically benefit from substituting the asset



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After determining that a contract contains a lease, an entity should identify the separate lease components within a contract. The right to use an asset should be a separate lease component if it meets both of the following criteria:

In a lease of land and other assets, the right to use land should be accounted for as a separate lease component unless the effect of such accounting is insignificant. Contract consideration should be allocated to each separate lease component that has been identified. Activities (or costs of the lessor) that do not transfer a good or service to the lessee are not lease components in a contract.

Tip :

The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee.

The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract.



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Lease Payments

• Fixed payments (including optional periods if reasonably certain to exercise)• The exercise price of a purchase option (if the company is reasonably certain to

exercise)• Payments for termination penalties (if the lease term reflects that the lessee will

exercise the option to terminate the lease• Amounts probable of being owed by the lessee under residual value guarantees

Commencement Date

• Date that the asset is available for use

Lease Term

• Stated lease term• Renewal lease term if the company is reasonably likely to renew• Early termination - if the company is reasonably likely to terminate before the end of

the stated lease term

Lease Incentives • Lease incentives paid or payable to the lessee

Discount Rate• Implicit rate in the lease• Incremental borrowing rate• Risk-free rate (private entities only)

Initial Direct Costs• Includes only costs incurred as direct result of executing contract• Commissions• Payments made to existing tenant to obtain the lease



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Does the lease meets the criteria of a Finance Lease or Operating Lease?

Capital Lease criteria under ASC 840 vs. Finance Lease criteria under ASC 842

Criteria ASC 840 (Capital Lease) ASC 842 (Finance Lease)

Transfer of Ownership

The lease transfers ownership of the property to the lessee by the end of the lease term.

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term

Purchase Option

The lease contains a bargain purchase option. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Lease Term is majority of EconomicLife

The lease term is equal to 75 percent or more of the estimated economic life of the leased property. Except if the beginning of the lease term falls within the last 25 percent of the total estimated economic life.

The lease term is for the major part of the remaining economic life of the underlying asset. Except if the commencement date falls at or near the end of the economic life of the underlying asset.

Present Value of Lease Payments > = Fair Value

The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception

The present value of the sum of the lease payments (and any guaranteed residual value) equals or exceeds substantially all of the fair value of the underlying asset.

NoAlternative Use

N/A The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Although ASC 842 eliminates the economic life and fair value bright lines of 75 and 90 percent, it notes in the illustrationsthat using these thresholds is “one reasonable approach” to assess “major part of the remaining economic life” and “substantially all of the fair value”.

*

*

*



Initial Lease Liability & Right of Use Asset

Measure the Initial Lease Liability

Initial Lease Liability

Present Value of Unpaid Future Lease

Payments

=

Initial Right of

Use Asset

=Initial Lease

Liability

+Initial Direct Costs

Prepaid Lease

Payments

Lease Incentives Received

+ -

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Measure the Initial Right of Use Asset

+

Present Value of amount probable of being owed

under RVG (residual value guaranteed)



Operating Lease (lease costs is determined on a straight-line basis)

Lease Cost =# of Periods

in Lease Term

/

Amortization Expense

=Initial Right of Use

Asset /

# of Periods in Lease

Term

Interest Expense

=Initial Lease

Liability * Interest Rate

Finance Lease (Assuming straight-line amortization method)

&

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The amortization method may be straight-line or another systematic basis that is representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset.

Tip :

Sum of Undiscounted

Lease Payments for Lease Term

+Initial Direct

CostsIncentives Received

-(

(


THE NEW LEASE STANDARDA Closer Look – Financial Reporting Impacts

33

The new disclosure requirements include a number of new key measurements. Below are some of the more interesting requirements along with the disclosure example provided in the 842 standard:

• While short team leases (<12 months) don’t have to be accounted for under ASC842 there is a disclosure requirement.

• Lease classification disclosures

• Variable lease costs

• Various weighted average disclosures for remaining lease terms and also the discount rate


THE NEW LEASE STANDARDA Closer Look – Accounting Impacts – Lease Modification

34

Lease Modification is defined by ASC 842 as:

“A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease.”

Some examples of lease modification include…

• Granting an additional right of use not included in the original contract

• Extension or reduction to the term of an existing lease

• Full or partial termination of an existing lease

• Change to the consideration in the contract

Lease modifications should be evaluated for proper accounting treatment.


THE NEW LEASE STANDARDA Closer Look - Considerations

Evaluate the Supporting Systems and Data

Companies should consider selecting and implementing

a suitable technology solution to simplify the lease data gathering process, to

perform calculations & JE’s, to determine disclosures,

to interface with disbursements, etc.

Some PossibleTechnology Solutions

Ensure the Enterprise-Wide Lease Inventory is Reliable

Lessees should determine that all leases deployed

across the organization are identified on a timely basis and aggregated to create a

complete and accurate lease inventory and related lease

data elements.

The two most significant challenges will likely be data

collection and having proper systems in place.

Nakisa (SAP)

IBM TRIRIGA

ProLease

CoStar

Lucernex

AMTdirect

LeaseQuery

Visual Lease

Lease Accelerator


THE NEW LEASE STANDARDA Closer Look - Considerations

Be mindful of expected changes in the

business

The organization should assess whether changes are expected to take place in the business that will affect the

nature of the lease instruments.

Understand the new disclosures

Company executives will want to understand the financial reporting and

expanded disclosures under the new standard.

Look for embedded leases

If the organization enters into an arrangement that

identifies, and grants to entity right to use PP&E, it

constitutes a lease. Such arrangements may be embedded in service

arrangements.


LEASES ARE PREVALENTJust look at what companies are disclosing now

37

Target

ROU Asset = $0.9 - $1.4BnLease Liability = $1.2 - $1.7Bn

FedEx

ROU Asset = $13Bn+Lease Liability = $13Bn+

Citigroup

ROU Asset = $5BnLease Liability = $5Bn

Microsoft

ROU Asset = $5.2Bn - $6.6BnLease Liability = $5.2Bn - $6.6Bn


NEW LEASES STANDARD

38

Q&A

OUR APPROACH TO A SUCCESSFUL TRANSITION


TRANSITIONCritical Success Factors

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Gap Analysis

Analyze current state and identify gaps with the requirements under the new standard.

Resourcing

Identify and assess resource needs for current state gap analysis, implementation, and project management throughout the transition timeline.

Communication Strategy

Develop a strategy for communicating with investors about the impact of transition to the new leasing standards.

EducationProvide awareness and education to all stakeholders.

Project Management

Manage the implementation process and provide for appropriate change management protocols.

1

2

3

4

5


TRANSITIONStructured Approach

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Establish a Steering Committee

Perform Gap Analysis

Establish Transition Strategy (Remediation Recommendations)

Establish a Project Management Office

Assess Reporting CapabilitiesUpdate Critical

Accounting Policies

Update Financial Reporting

Controls

Update Financial Statements and

Other Reports

Transition Phases &

Key Elements

Protiviti’s approach to transition is divided into three phases – Analyze, Design, and Implement. Each phase addresses specific key transition elements.


TRANSITION Six Elements of Infrastructure

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Methodology

Business Policies

Business Processes

People

Reporting

Systems and Data

Analyze

Methodology

Business

Policies

Business Processes

Systems and

Data

Reporting

People

Analyze

During the Analyze Phase, it is important to consider the implications to your organization’s infrastructure. You can do this by using the Protiviti Six Elements of Infrastructure Model.


TRANSITIONCross-Functional Collaboration

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• While CFOs will likely own the responsibility to assess the requirements of the new standard, its implications and the appropriate transition plan, the responsibility for the design and implementation of solutions must be cross-functional in nature.

• The effort itself, must be overseen through a project-driven discipline and approach (perhaps by a project management office (PMO) structure for large, complex organizations).

Responsibility

• Collaborative involvement and appropriate change management activities are critical to an effective and efficient revenue recognition transformation initiative.

• In particular, change management becomes a major determinant of success by overseeing the allocation of resources, establishing the transition framework and supporting appropriate training at all levels of the organization.

Cross-Functional and Collaborative Involvement

Sales & Marketing

Accounting & Finance

Legal

HR

Internal Audit

IT


TRANSITIONLessons Learned

44

Effective project management and communications are key to the successful execution of a transformation project. Even in the presence of a strong PMO and communications plan, the following challenges may be encountered with major transformation initiatives:

Resistance to Change

Adversity to change is a common barrier encountered on transformation initiatives. It is important tounderstand the impact of change on people, processes and systems both within and beyond theaccounting and finance organizations. While management may be fully engaged, lower levelpersonnel performing affected tasks may not have a broad enough perspective on the necessity ofthe change. Often, these are the same individuals that project teams rely on to understand thecurrent state.

Executive Champions and Organizational Buy-in

Appropriate executives must be identified and their buy-in of the transformation effort must besecured. It is important that the tone regarding the transformation is consistent across theorganization.

Knowledge/Resource Bottlenecks

Knowledge of processes and applications resides in pockets. “Bob is the only one who knows howthat system works and he is out for two weeks.” These situations can become pervasive and turninto bottlenecks, impacting the project team’s ability to deliver against the project plan and jeopardizethe achievement of milestones.

Business Disruption

Transformation initiatives most always have an Impact on the ability to perform current processes atthe current level, both for stakeholders and internal project team members with other responsibilitiesthat must be met. It is critical for management and the steering committee to establish expectationsup front with internal resources that will be directly involved in the project.

Buy-in at the Individual Level

End users may struggle as they focus on how the change impacts them – the impact could be thattheir roles and responsibilities change or additional processes must be completed as a part of theirdaily work.

Proper Program/Project Management Capabilities

Appropriate project management elements need to be in place that ensure consistentcommunication, realistic plans, schedules and resources.


TRANSITIONRisks Associated with Transition

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The most significant risks inherent in the conversion process include, but are not limited to:

Ineffective project plan1

Insufficient time to complete the project2

Inaccurate diagnostic results, leading to an inadequate foundation for preparing a focused project plan3

Limited or lack of audit committee involvement and support4

Limited internal/external resources5

Improperly trained internal staff and/or internal staff lacking in accounting knowledge6

Limited or no involvement from departments outside the accounting function (e.g., IT, legal, HR)7

Last-minute surprises, related delays and significant rework because the external auditors are not fully engaged in the project

8

Unanticipated issues9

Lack of external auditor capabilities 10


TRANSITIONConsiderations to Estimate the Effort, Time and Cost Required for Transition

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• Is your company a global organization?

• What resources, both internal and external, are available to assist with the conversion? Do you already have internal knowledge?

• Are resources available from all affected areas of the organization, including IT and operations, to participate in the project?

• Is your organization highly centralized or decentralized?

• Does your organization engage in extremely complex or sophisticated financial transactions?

• Does your organization use a common ERP system or multiple reporting systems?

• How resilient is your organization (i.e., how well does it embrace and adapt to change)?

• Will your organization view the conversion as an opportunity to take a fresh look at everything or just change what is required to change?

• How well has your organization handled special long-term projects, such as Sarbanes-Oxley Act compliance?

• How familiar are your company’s external auditors, and specifically your audit team, with the subject matter?

• What are the impacts on your infrastructure?


THANK YOU

47

Q&A

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